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New HorizonsLegal and structuring developments for new internationalstructured debt transactions

In our New Beginnings publication of November 2009, we set out our views of thechanges required to be made to securitisation legal analysis and documentation inorder to address some of the issues faced by market participants over the past twoyears. Since that publication just over six months ago, as we anticipated, a functioningif limited primary market can be said to exist in a number of key consumer assetclasses led by RMBS and the debate has moved on considerably in terms of regulationand standardisation of documentation.

Introduction

In light of these developments, the aim of this publication is to widen the debate further through an exposition of market trends acrossa range of international jurisdictions which examine the following important themes:

n Regulatory developments covering the impact of aspects of rating agency regulation in the US, a review of the implementation ofregulatory changes in key European jurisdictions and a detailed review of the impact of the SEC’s proposed changes to RegulationAB on non-US issuance;

n The impact of bank insolvency on structured transactions focussing on UK legal analysis and practical experience from Holland;

n Current challenges for securitisation derivatives ranging from the fallout from the Perpetual litigation to synthetic securitisations; and

n Market updates on key asset classes such as RMBS and CMBS restructurings as well as an article explaining why structuredutility bonds have proved to be a major survivor asset class over the last two years.

Being aware that securitisation has been blamed by politicians for much of the financial crisis, it is hardly surprising that the flurry ofregulatory initiatives continues apace to address perceived flaws in the pre-crisis securitisation model. Notwithstanding thewell-rehearsed critique of some aspects of the pre-crisis securitisation model, there continues to be broad consensus that afunctioning securitisation market is a prerequisite to a sustained recovery and availability of credit to the wider economy. Indeed, oneconsistent theme throughout 2009 and 2010 has been clear support for the re-emergence of a functioning securitisation market bynational governments, regulators and supra-national bodies. José Manuel González-Páramo, member of the executive board at theECB stated in an interview in January 2010:

“Securitisation markets provide an important source of additional funding for banks. They also allow banks to transfer risk, optimisetheir balance sheet structures and use capital in a potentially more efficient way. If done correctly, under the right market conditionsand in compliance with the regulatory framework, the benefits of securitisation can be passed on to borrowers in the form of lowerborrowing costs.”1

The key question for regulators and central banks over the last year or so seems to be focused on what “done correctly” should meanand the plethora of proposed regulation and industry best practice has been focussed on addressing this well-intentioned goal.However, whilst certainly well-intentioned, some of the initiatives may in fact prove to result in unintended consequences. Moreover,despite almost unanimous political espousal of the need for joined up global solutions to a globalised financial market, the reality hasin many cases been coloured by local political motivations. What we hope to draw out in this publication are the themes which arecommon across national boundaries as well as to highlight any inconsistencies of approach and the likely consequences of suchdisparities. However, many of the regulatory initiatives do seem to be pointing in broadly the same direction so harmonisation of boththe substance and spirit of these initiatives will be key.

We hope you find this publication useful and thought-provoking. Should you have any questions, comments or observations, pleaseget in touch with your usual Structured Debt contacts at Clifford Chance or one of the Structured Debt partners listed at page 101.

1 Remarks by José Manuel González-Páramo, a member of the executive board at the ECB in an interview with Credit dated 22 January 2010.http:www.risk.net/credit/news/1588142/transparency-key-securitisation-revival-ecb-s-gonz-lez-p-ramo

Kevin Ingramon behalf of the International Structured Debt GroupLondon, June 2010

Regulatory Developments1. Investor disclosure 1

2. Moving the regulatory goal-posts – how will non-U.S. ABS issuers 7be affected by the recent SEC reforms?

3. SEC’s proposed changes to Regulation AB will significantly impact U.S. 15private structured financings

4. Implications of the SEC Rule 17g-5 for structured finance transactions 25

5. How the German legislator hopes to save the German financial system 29

6. Significant risk transfer and synthetic securitisation 35

7. ECB liquidity transactions – a refresher and an outlook on changes to come 41

Insolvency8. The Financial Services Compensation Scheme and The Banking Act 2009 45

– dealing with the set-off risk

9. A short analysis of the operational risks of securitisation in relation to 49insolvent bank originators

10. Case study of the bankruptcy of a Dutch retail bank – testing the waters 55for Dutch securitisations

11. Perpetually deprived of using “flip” provisions? 63

12. Launch of the first French securitisation company 69

Recent Market Developments in Structured Asset Classes13. RMBS revisited 73

14. Regulated utilities still have the X factor 77

15. Restructuring of CMBS transactions in Germany 85

16. Coeur Défense: French Appeal Court judgment reassures the markets 91

17. Japanese CMBS market – the story so far... 95

18. Assessing the impact of Rome I developments in the context of 97trade receivables financings

Contents

1. Investor disclosure

© Clifford Chance LLP, 2010

In Europe, the European Central Bank hasproposed asset-backed securities loanlevel disclosure for the Eurosystemcollateral framework and the Bank ofEngland has launched a consultativepaper extending eligible collateral in theDiscount Window Facility and informationtransparency for asset-backedsecuritisations. In addition, theamendments to Article 122a of the CapitalRequirements Directive (“Article 122a”) setout increased Pillar 2 due diligenceobligations on credit institution investors,creating a further momentum for accessto more extensive data.

In the United States, April 2010 saw theU.S. Securities and ExchangeCommission publish sweeping proposalsto update and expand the regulation ofofferings of asset-backed securities andother structure finance transactions inboth the public and the private markets.

These parallel initiatives are designed toincrease transparency for investors inthe securitisation markets and to reducereliance on rating agencies. In our view,these initiatives may well start to shapeinvestor expectations prior to theirformal effectiveness.

The InitiativesEuropean Central Bank – loan-levelinformation in the EurosystemCollateral Framework

On 23 December 2009 the EuropeanCentral Bank (the “ECB”) launched apublic consultation on loan-by-loaninformation requirements for asset-backed securities in the Eurosystemcollateral framework. In April 2010 theECB published a summary report of theresults of the public consultation, whichrevealed strong support for the initiative.The ECB initiative centres on the

development of a standardised reportingtemplate for disclosure of loan-by-loandata on an ongoing basis for each assetclass of securities. The initial template isfor RMBS structures, with templates forCMBS, CLOs and other asset classes tofollow. The data collected from thesestandardised templates would then bemade available through a subscription-based data portal system.

While there was broad support for theprovision of loan-level data, there appearsto be significant divergence in theresponses the ECB received in respect ofa framework for handling the data. Twooptions had been presented: a singledata entry point versus a set of registeredportal providers. Whereas certainrespondents preferred one option or theother, other respondents proposedalternate hybrid structures, or suggestedthe collecting and handling of loan-leveldata through existing marketinfrastructure including disseminationthrough regulated stock exchanges.

In view of the positive consultation theGoverning Council of the ECB agreed on22 April 2010 that the study phase of theloan-level initiative could be consideredcomplete and that the Eurosystem couldproceed with its preparatory work for theestablishment of loan-level informationrequirements. The preparatory period isexpected to last approximately sixmonths. It is envisaged that theGoverning Council will assess the resultsof the preparatory work after summer2010, after which it would announce theloan-level data requirements.

Bank of England – informationtransparency for asset-backedsecuritisations

In March 2010 the Bank of Englandpublished a consultative paper seeking

views on, among other things, theBank’s initiative to require greatertransparency in relation to asset-backedsecurities and covered bonds as part ofthe eligibility criteria for instrumentsaccepted in its operations, including theextended-collateral long-term repooperations, the Special Liquidity Scheme(while it is outstanding), and the DiscountWindow Facility.

The proposed enhanced disclosurerequirements would apply to all forms ofasset-backed securities accepted by theBank, from all jurisdictions, with specificrequirements applied to each separateasset class. The increased levels ofdisclosure would be provided publicly tohelp market-wide transparency ratherthan being required solely on a bilateralbasis to the Bank. Broadly, the Bank isconsidering the following eligibility criteriafor securities accepted in its operations:(1) provision of loan-level data andinclusion of certain stratification tables ininvestor reports; (2) availability of cash-flow models; (3) availability of legaldocumentation and summary of structuralfeatures; and (4) provision of monthlyinvestor reports (including disclosure ofmark-to-market of swaps, accountbalances and permitted investments).

The undisputed mantra in the aftermath of the financial crisis is the promotion ofincreased disclosure to investors as a key element in tackling the perceivedinformation asymmetry between investors and issuers of asset-backed securities. Inthe drive to create greater transparency in securitisation markets several initiatives areunderway on both sides of the Atlantic to promote such a goal.

“While there was broadsupport for the provisionof loan-level data, thereappears to be significantdivergence in theresponses the ECBreceived in respect of aframework for handlingthe data”

New Horizons 2

The deadline for submitting comments onthe proposals was 30 April 2010. CliffordChance was among those submitting aresponse and was broadly supportive ofthe initiative. In the light of commentsreceived and following furtherconsultation if necessary, the Bank ofEngland will finalise its proposals for thedevelopment of its market operations.

Securities Exchange Commission –regulatory changes to asset-backedsecurities

On 7 April 2010 the US Securities andExchange Commission (the “SEC”)published sweeping proposals to updateand expand the regulation of offerings ofasset-backed securities and otherstructured finance transactions in the USin both the public and the privatemarkets. If adopted in substantially theircurrent form, the proposals in the SECregulatory statement (the “ABS Release”)would have a wide-ranging impact onparticipants in the asset-backed securitiesmarkets in the United States, including onissuers and underwriters outside theUnited States who would seek to accessthe deep investor base in the UnitedStates for RMBS, Credit Card ABS,ABCP and, potentially, certain coveredbonds. Moreover, if the proposals areadopted, the disclosure requirements forpublic transactions would also becomeeffectively mandatory for private offeringsin the United States under Rule 144A andRegulation D of the Securities Act of1933. The proposals are subject to a90-day consultation period with adeadline of 2 August 2010.

While certain of the proposed newdisclosure requirements foreshadow theproposals of the ECB and the Bank ofEngland, others extend beyond what iscurrently contemplated in the Eurosystemand the sterling markets. For the firsttime, disclosure in Rule 144A

transactions will effectively be subject toregulation by the SEC, even if the primarymarket for the securities offered is outsideof the United States. Non-US issuers inRule 144A transactions will be required toundertake to deliver to investors promptlyupon request detailed portfolioinformation, including information aboutthe underlying pool on an asset-by-assetbasis. We believe this requirement willmean such non-US issuers will effectivelyhave to comply with such informationrequirements upfront in order to be ableto deal promptly with an investor request.

In addition to the requirements for asset-level data, the proposals in the ABSRelease also seek to enhance the pool-level information traditionally provided inmost offering documents. Asset-levelinformation will be accompanied by acomputer programme (the “waterfallcomputer programme”) that allowsinvestors to perform stress tests on theportfolio cash flows so that they canmake their own assessment of the abilityof the assets to service the amountspayable on the securities in variousscenarios. Like the asset data, thiswaterfall computer programme would bean integral part of the prospectus so thatissuers would be required to provide thewaterfall computer programme at thetime of filing the preliminary prospectus,with data accurate as of the date of thefiling. Similarly, as a prospectusrequirement, the waterfall computerprogramme would be filed with the finalprospectus with data accurate as of thedate of the filing.

The SEC proposals also seek to enhancestatic pool disclosure by proposing fournew disclosure requirements regardingstatic pool information: (i) narrativedisclosure describing the static poolinformation presented; (ii) a description ofthe methodology used in determining or

calculating the characteristics presentedand a description of any terms orabbreviations used; (iii) a description ofhow the assets in the static pools shownin the prospectus differ from the poolassets underlying the securities beingoffered; and (iv) if an issuer does notinclude static pool information or includesdisclosure that is intended to serve asalternative static pool information, anexplanation of why they have not includedstatic pool disclosure or why they haveprovided alternative information.

It is also worth noting that the SECproposals continue the pull-back fromreliance on rating agencies and thehardwiring of ratings into the regulatoryframework. For example, the requirementfor ratings for a shelf-registration has beenremoved. At one level it could be observedthat the SEC proposals are intended toallow, or even pressure, investors toperform their own analysis in the sameway as a rating agency would do.

For more details of the SEC proposal andtheir potential impact see articles 3 and 4respectively.

Current EuropeanLegislative FrameworkCapital Requirements DirectiveArticle 122a

Article 122a is scheduled to be applicableto new securitisations issued on or after 1January 2011 and after 31 December2014 to existing securitisations wherenew underlying exposures are added orsubstituted after that date. Creditinstitutions investing in asset-backedsecurities will, pursuant to Article 122a,have to be able to demonstrateprocedures to monitor performanceinformation on the exposures underlyingtheir securitisation positions.


3 New Horizons


New Horizons 4

Article 122a imposes punitive capitalrequirements on an investor who fails byreason of negligence or omission tocomply with the due diligencerequirements set out in Article 122a(4)and (5). These require investor creditinstitutions to be able to demonstrate acomprehensive understanding of, and tohave formal policies and procedures foranalysing and recording: (i) informationdisclosed by originators as to the interestthey are maintain; (ii) the riskcharacteristics of the securitisationpositions and their underlying exposures;(iii) the prior performance of the originatoror sponsor in securitising that assetclass; (iv) statements by the originators asto their due diligence on the pool and anycollateral; (v) methodologies by which thecollateral is valued, and the policies of theoriginator to ensure the independence ofthe valuer; and (vi) the structural featuresof the securitisation which could impactthe performance of the securitisationposition it holds. Investors must alsomonitor performance of theirsecuritisation positions as a whole,including the diversification, default ratesand loan to value ratios of theirentire portfolios.

Unlike the SEC proposals, Article 122adoes not remove ratings from theframework but reduces their importanceby listing the ratings as only one of manyfactors investors can take into account.This is consistent with our view that USregulators are going further and quicker inremoving rating agencies from theregulatory framework whereas Europeanregulators are currently more concernedwith reducing over-reliance on ratings.

EU disclosure and transparencyrequirements – The DirectivesTriptych

The legal foundation of the EU disclosureand transparency regime applicable to

issuers of securities admitted to tradingon EU regulated markets is set out overthree directives: the “ProspectusDirective”, which sets out the contentrequirements of a prospectus; the“Transparency Directive”, which sets outongoing disclosure obligations onissuers; and the “Market AbuseDirective”, which regulates the use anddisclosure of inside information andprohibits market manipulation.

The Prospectus Directive requires that aprospectus contain all information which,according to the particular nature of theissuer and the securities, is necessary toenable investors to make an informedassessment of the assets and liabilities,financial position, profit and losses andthe prospects of the issuer.

The Transparency Directive imposes arequirement for issuers to disclosureregulated information in a mannerensuring fast access to such informationon a non-discriminatory basis. “Regulatedinformation” means any informationrequired to be disseminated by the issuerunder the Transparency Directive,including any inside information requiredto be disclosed under Article 6 of theMarket Abuse Directive. Pursuant toArticle 12(2) of the Transparency DirectiveImplementing Directive, regulatedinformation must be disseminated to aswide a public as possible and as close tosimultaneously as possible.

Article 6(1) of the Market Abuse Directiverequires an issuer whose securities areadmitted to trading on a regulated marketto inform the public as soon as possibleof inside information which directlyconcerns that issuer. “Inside information”

is defined as any information of a precisenature which has not been made public,relating directly or indirectly, to one ormore issuers of financial instruments or toone or more financial instruments andwhich , if it were made public, would belikely to have a significant effect on theprices of those financial instruments or onthe price of related derivative financialinstruments. In other words, information areasonable investor would be likely to useas part of the basis of his or herinvestment decisions. The Market AbuseDirective further mandates insideinformation to be made public by theissuer in a manner which enables “fastaccess and complete, correct and timelyassessment of the information” and thatany significant changes concerning alreadypublicly disclosed inside information ispromptly disclosed through the samechannel as the one used for publicdisclosure of the original information.

Conforming ProposedInitiatives to the CurrentRegulatory Regime in EuropeThe underlying rationale of the initiativesof the Bank of England, ECB and SECare premised on the fundamentalprinciple that increased transparency andaccess to information will help re-establish the asset-backed securitiesmarkets. Broadly, the initiatives all movein the same direction, which creates thescope for the possibility of a consistent (ifnot coordinated) approach betweenthese three important market areas. Atthis stage it is clear that the SECapproach is significantly more prescriptivethan the initiatives currently in place inEurope. Market participants and

“Whatever form the electronic framework for housing themass volume of data takes, the concept of the prospectuswill in our view likely need to expand over time”

5 New Horizons


observers will be keenly following thedevelopment of a prescriptive approachin Europe and its potential interaction withthe regulatory reforms across the Atlantic.The devil, as they say, will be in thedetails: the promotion of one computerdata modelling system by the SEC couldresult in incompatibility with the dataportal system promoted by the ECB orthe proposed cash flow model disclosureof the Bank of England.

It is also worth mentioning that just asinconsistencies between the initiativesacross the Atlantic may develop as theseinitiatives become implemented, theseare not the only contemplated initiativesin their respective jurisdictions.Overlapping regulatory reforms bydifferent agencies and regulatory bodieswithin these jurisdictions couldinadvertently create greater regulatorycomplexities and hurdles contrary to thestated goals of greater simplicity andtransparency. The different agencies andregulatory bodies acknowledge themultiple initiatives and, as reflected in theBank of England Consultative Paper,there is support for consultation betweeninstitutions to ensure, to the extentpossible, consistency andcomplementary requirements.

Data Manipulation and theProspectus Directive

Proposed amendments to the ProspectusDirective were published in September2009. Following the publication of the draftreport of the Rapporteur to the Committeeon Economic and Monetary Affairs of theEuropean Parliament in January 2010 it isthe apparent intention to agree and enactan amending Directive some time later this

year. One of the more significant changesproposed relate to the proposal to abolishthe current 2,500 word limit on theprospectus summary and its replacementwith “key information” – namely, sufficientinformation to enable investors tounderstand the nature and the risks of thesecurities and to take investment decisionson an informed basis. What constitutes“key information”, however, is still left to bedetermined. The logical progression wouldappear to be for “key information” to beinformed by the due diligencerequirements imposed by Article 122a ofthe Credit Requirements Directive and, intime, the initiatives being put forward bythe ECB in the case of the Eurosystemand the Bank of England in the UK.

These initiatives, and the initial responsesfrom market participants, reveal thatinvestment decisions are made, andpursuant to Article 122a are required tobe made, on the basis of processes ofdata manipulation. The SEC proposalsrequire posting such data in conjunctionwith the waterfall computer programmeon EDGAR, thus forming part of theprospectus requirements. In other words,the data in the waterfall computerprogramme is at par with the prospectusdisclosure. Both the ECB and Bank ofEngland initiatives contemplate thedisclosure of asset-level data through theuse of a data portal or website frameworkaccessible to investors. The prospectus,however, is fundamentally a legaldisclosure document which sets out theinformation in accordance with therequirements of the Prospectus Directive.What has been apparent for some time,however, is that investor decisions are

often made with more emphasis on thedata and the manipulation thereof. In ourview it would be inappropriate for aprospectus to contain pages of granular,raw asset-level data. The disclosure inthe prospectus is, however, likely toexpand to contain more narrowcategorisations for stratification of datathan previously was the case with suchcategories more properly defined in thecontext of the securitisation. Unlike theSEC proposals, there is no currentdiscussion at the European regulatorylevel of the treatment of cash flow modelprogrammes and data portals in thecontext of prospectus disclosurerequirements or their status vis-a-vis theprospectus. Whatever form the electronicframework for housing the mass volumeof data takes, the concept of theprospectus will in our view likely need toexpand over time beyond an informationmemorandum and extend to the asset-level, cash flow models and other dataprovided in these “data portals” (whateverform they take).

Data Protection and InvestorDisclosure

Increased disclosure requirements willrequire a fine balance to be drawnbetween data protection laws and therequirements imposed on issuers todisclose information under theTransparency Directive and the MarketAbuse Directive. Issuers (and any thirdparty administrators) of asset-backedsecurities will need to take particular careto ensure that the identity of obligors ofthe underlying assets which are subjectto data protection or confidentialityrestrictions is fully protected and cannotbe inferred from the informationcontained in the asset data files. Althoughasset-level reporting may be restricted bydata protection laws and banking secrecylaws, having conducted a pan Europeanlegal analysis, we do not foreseeinsurmountable hurdles in this respect.

“Overlapping regulatory reforms by different agenciesand regulatory bodies within these jurisdictions couldinadvertently create greater regulatory complexitiesand hurdles”

New Horizons 6


Disseminating Data under theTransparency and Market AbuseDirectives

The Transparency Directive and MarketAbuse Directive stipulate requirements fornon-discriminatory, wide public disclosureof information. National legislationimplementing the Transparency Directivemay specify the manner in which suchdisclosure must be disseminated. Forexample, in the UK the Disclosure andTransparency Rules of the FinancialServices Authority require that alldisclosure of such regulated informationby issuers whose securities are admittedto trading on a regulated market in, andwhose home state is, the UK be madevia a FSA approved regulatory informationservice (“RIS”). Currently these includePRS Newswire and the London StockExchange’s Regulatory News Service(“RNS”). An information service mustsatisfy certain criteria in order to beapproved by the FSA to qualify as a RIS.These criteria include a demonstratedability to disclose regulated information tothe public/media in a manner ensuringfast access to such information on a non-discriminatory basis. Issuers will need toconsider these requirements in choosinghow to disseminate asset level informationconsistent with the requirements of theDirectives. The ECB initiative in turn willneed to develop the eligibility criteria forany third party data portal providers inlight of any limitations or restrictionsimposed by national regulatory bodies.

The investor disclosure initiativesuniformly support the disclosure anddissemination of enhanced data to allinvestors. This is in line with the broadprinciples of the Market Abuse Directive.However, the proposals in respect of asubscription-based data portal frameworkfor handling data may prove moreproblematic in some jurisdictions than inothers for purposes of the Market Abuse

Directive. The issue is whether asubscription-based service falls foul ofthe definition of “inside information” as“information of a precise nature which isnot generally available…” In the UK, theFSA Handbook on the Code of MarketConduct provides guidance on this point,stating that, in the opinion of the UKFinancial Services Authority, factors to betaken into account in determiningwhether or not information is generallyavailable, and are indications that it is(and therefore not inside information)include, among other things, whether theinformation is otherwise generallyavailable, including through a publication(including if it is only available on paymentof a fee). Other national regulators,however, may not take the same view.

Moving forward…

It is clear that the proposals initiated bythe ECB, the Bank of England and theUS Securities Exchange Commission willgo forward, even if not necessarily in theircurrently proposed form. The feedbackon the ECB consultation process waspredominantly favourable and while it isexpected that similar feedback will bereflected in the current Bank of Englandconsultations, market participants andother observers will undoubtedly bekeenly following the comment process onthe sweeping SEC proposals.

The due diligence requirements imposedon credit institution investors under Article122a will institutionalise the momentumfor increased investor disclosure. Whilethe due diligence requirements underArticle 122a do not go as far as the SECproposals in their marginalisation of therating agencies, the push for increasedaccess to data and proposals promotingthe disclosure of cash flow models reflecta decisive move in Europe to decreasemarket reliance on rating agencies in thelonger term.

At a minimum, we expect that theproposals will start to establish a newlevel of “best practice” both in theEuropean and US securitisationmarkets. As mentioned above, the pushfor increased investor disclosure islinked to a wide-spread belief that moretransparency in the markets throughincreased investor disclosure will re-open the securitisation markets. Betteraccess to data on the underlying assetsmay contribute to the re-opening of themarkets but we do not believe it will bethe overriding contributing factor. Theimplementation of these proposals,however, should help with the creationand maintenance of a more orderedsecuritisation market in the longer term,which is a welcome development.Within Europe, pan-European andnational regulatory and legislativeframeworks will need to be harmonisedto decrease administrative burdens ofenhanced disclosure on issuers ofasset-backed securities. In this respect,hopefully, the broadly consistent “inprinciple” approach across the variousinitiatives will be sustained throughimplementation of more detailed rulesand prescriptive approaches. However,we are concerned that the proposedspeed of implementation coupled withthe political imperative of being seen tobe “doing something” to addressperceived short comings in the financialmarkets, will lead to poorer qualityregulation and legislation that is not fullythought through or “joined-up”.Nevertheless the proposedrequirements that effectively all investorsin structured finance products receiveasset level data accompanied withaccess to data portal systems or, in thecase of the US, a bespoke computermodel, has the potential to substantiallychange how the securitisation marketsoperate on both sides of the Atlantic.

2. Moving the regulatory goal-posts – how will non-U.S. ABS issuers beaffected by the recent SEC reforms?


Product areas such as residentialmortgage-backed securities (“RMBS”),asset-backed securities supported bycredit card receivables (“Cards ABS”),synthetic securities and other structuredfinance transactions directly or indirectlybacked by financial assets, asset-backedcommercial paper (“ABCP”) and,potentially, certain covered bonds will beimpacted by the ABS Release.

Notwithstanding the harmonisation ofdisclosure levels in the public and privatemarkets, we believe that the proposalswill encourage non-U.S. issuers to preferthe private markets in the U.S. over theregistered public market.

Reform of the regulation of rating agencieswas a focal point in the US even before thefinancial crisis. The Credit Rating AgencyReform Act 2006 formalised the SEC’s rolein regulating rating agencies and the SEChas adopted a number of separate rulesimplementing the “regulation of nationallyrecognised statistical rating agencies”(“NRSROs”) including Rule 17g-5(discussed briefly below).

Whilst Rule 17g-5 has beenimplemented, it is very difficult toforecast when the proposals set out inthe ABS release will come into effect orwhat amendments will be made (if any)prior to implementation. If adopted, theprovisions of the ABS Release will applyonly to asset-backed securities andother structured finance productsissued in the U.S. after the date set bythe SEC for implementation of theproposals and the SEC has indicated

that a transition period will be providedfor. However, even prior to adoption, weexpect that the proposals will change“best practice” in the U.S. securitisationmarkets increasing the asset disclosureexpected by investors, particularly asthe strong position taken by the SEC ina number of areas, such as theprovision of loan-level data issue,mirrors some of the recent proposals

consulted on by the European CentralBank and the Bank of England.

This memorandum focuses on theimpact of the ABS Release on non-U.S.issuers and underwriters of asset-backed securities and otherstructured finance products sold intothe United States in either the public orprivate markets.

On 7 April 2010, the U.S. Securities and Exchange Commission (the “SEC”) publishedsweeping proposals to update and expand the regulation of offerings of asset-backedsecurities and other structured finance transactions in the U.S. for both public and, forthe first time, private offerings under Rule 144A and Regulation D of the securities.The proposals, which were made in a 667–page regulatory statement (the “ABSRelease”), would involve substantial revisions to Regulation AB (“Regulation AB”)under the U.S. Securities Act of 1933, as amended (the “Securities Act”), and otherU.S. rules regarding the offering process, disclosure and reporting for asset-backedsecurities and other structured finance products.

New Horizons 8

Summary of key changes for the Rule 144A marketn For the first time, disclosure in Rule 144A transactions will be effectively subject

to regulation by the SEC, even if the primary market for the securities offered isoutside of the United States, as issuers of ABS or other structured financeproducts will be required to undertake to provide the same level of information aswould be required in an SEC-registered transaction promptly upon request by aprospective purchaser.

n Enhanced “loan level” disclosure will be required on each of the underlying poolassets for virtually all U.S. offerings, with specific data fields identified by the SECfor 11 different asset types.

n Periodic data will need to be provided on assets that have been put back to thesponsor or originator for breaches of point-of-sale representations and warranties.

n The loan-level information must be accompanied by a computer programme thatallows investors to “stress test” the portfolio cash flows, so that they can maketheir own assessment of the ability of the assets to service the amounts payableon the securities in various scenarios.

n Information required from issuers of synthetic securities will include details of thedifference between cash and underlying credit spreads of the underlying assets.

n Issuers will be required to deliver to the SEC details of each issuance of securitiesin Rule 144A transactions within 15 days of issuance on a prescribed form.

n The approach to disclosure and the offering process in the public markets, asdetailed below, is likely to set the standard for best practice in the Rule 144Amarket and, possibly, in the international markets.

Key provisions of the ABSRelease for non-U.S. IssuersHistorically public transactionsregistered with the SEC have been theU.S. distribution channel used primarilyby non-U.S. issuers for large RMBS andCards ABS transactions. Whereasofferings using Rule 144A andRegulation D have generally been thedistribution channel used by non-U.S.issuers located in emerging markets orfor transactions backed by assets thatrequire a more bespoke selling effort, aswell as by less-frequent non-U.S.issuers of RMBS and Cards ABS.Accordingly, the impact on both publicand private transactions by non-U.S.issuers is discussed below.

New disclosurerequirementsResponding to a perceived lack ofdisclosure to investors in the asset-backed market prior to the creditcrisis, the SEC in the ABS Releaseproposes substantially enhanceddisclosure requirements.

Loan-level reporting requirements

Historically, the only statistical dataprovided to investors in asset-backedsecurities was at the “pool” level. Underthe proposals in the ABS Release,whether or not shelf registration is used,issuers will be required to includedetailed loan-level data at the time ofissuance, when new loans, cardholderaccounts or other assets are added tothe pool underlying the securities, and onan on-going basis in periodic reportspursuant to Sections 13 and 15(d) of theExchange Act.

Issuers of Cards ABS do not have toprovide loan-level data. The underlyingloan-level data will be provided intocombinations of standardised

“distributional” groups and data will beprovided on a group-level basis.

ABS issuers may struggle at first tomeet this new requirement for a varietyof reasons, including IT or othertechnical difficulties in obtaining theinformation and conflicts with local dataprotection and bank secrecy laws. TheSEC has set out a limited six-day“hardship” exemption but this is aimedat administrative difficulties with makingthe filing rather than difficultiesobtaining the information. A key

concern for European issuers is theadditional cost of complying withinconsistent regulation by the SEC, theEuropean Central Bank and potentiallythe Bank of England. A level ofinternational coordination would bedesirable for data disclosure purposes.

Waterfall computer programme

The purpose of the requirement to file acomputer programme of the contractualcash flow provisions of the offeredsecurities in a prescribed source codewith the SEC is to provide users with the


9 New Horizons

Rule 17g-5One of the main themes underlying the ABS Release is the perceived failure of theNRSROs most directly involved in the asset-backed securities markets to correctlyassess the risk of default in many asset-backed securities and the over-reliance ofinvestors on these rating agencies. Accordingly, the proposals in the ABS Releaseseek to provide to investors all the data and analytic tools necessary to allow themto make a full evaluation of the risks inherent in any structured product offering,effectively seeking to de-emphasise the role of the NRSROs going forward.

To further the SEC’s aim of decreasing investor reliance on issuer-solicited ratings,Rule 17g-5(a)(3) (the “Rule”) prohibits NRSROs from issuing or maintaining creditratings on certain structured finance products unless information that is provided tothe NRSRO engaged by the securitisation issuer is also provided to a passwordprotected website which is accessible by other NRSROs. By making this informationmore widely available, the Rule is designed to promote ratings unsolicited by theissuer on issuance and to facilitate ongoing monitoring by NRSROs which havepublished such ratings, including ratings paid for by subscribers.

As a result of the Rule, NRSROs have stated that they will require the partyappointing them, as a term of engagement of the NRSRO, to agree that the sameinformation which is provided to the engaged NRSRO will be posted to the websiteaccessible to all NRSROs.

Issuer compliance with Rule 17g-5 will necessitate some changes to currenttransaction practice, for example, legal opinion disclosure language may need to beadapted and there will be some additional prospectus disclosure. However, recentlyrating agencies have been providing structural queries and comments in commenttables and have requested written responses to those comments. This will facilitatethe provision of information to the password protected website. Whilst there willinevitably be some issues to overcome in the first transactions in Europe required tocomply with this rule, European issuers will now have the benefit of observing thecompliance of US issuers with these requirements. Compliance, therefore, is likely toinvolve mirroring the developing market standards in the US.


New Horizons 10

ability to build in their own assumptionsregarding the future performance andcash flows from the pool assets, includingbut not limited to, assumptions aboutfuture interest rates, default rates,prepayment speeds, loss-given-defaultrates, and any other assumptions requiredto be described under Item 1113 ofRegulation AB; thereby reducing aninvestor’s dependence on theperformance assumptions of the sponsorand/or the rating agencies. The waterfallcomputer programme must allow the userto integrate those assumptions with theasset data file required to be madeavailable by the issuer at the time of theoffering and on a periodic basis thereafter.

Issuers would be required to provide thewaterfall computer programme at thetime of filing the preliminary prospectusand the final prospectus with dataaccurate as of the date of the filing.

Non-U.S. issuers, particularly smallerissuers, may be concerned about takingresponsibility for the waterfall computerprogramme, especially where,historically, the transaction “model” mayhave been prepared by the arranger onbehalf of the issuer. A similarrequirement is proposed by the Bank ofEngland in its current consultation on itsDiscount Window Facility. In addition,underwriters of asset-backed securitieswill need to give consideration to what“due diligence” they need to performwith respect to the accuracy of thewaterfall computer programme.

Matters relating to transaction parties

The issuer would be required to disclosethe amount, if material, of securitisedassets originated or sold by the sponsoror an identified originator that were putback to the sponsor or originator forrepurchase as a result of a breach of apoint-of-sale representation andwarranty on a rolling three-year basis.

Summary of key changes affecting SEC registeredtransactionsIn addition to the requirements for “loan level” disclosure, a computer programmebased on the “waterfall” contained in the transaction documents to be filed with theSEC and data on assets put back to the sponsor or originator as a result of abreach of representation or warranty, the following proposed changes impact theregistered market:

n An investment grade credit rating will no longer be a factor in determiningeligibility for shelf registration; instead, eligibility for shelf registration will requirethe following:

• Retention by the programme’s sponsor of a five percent “vertical” slice ofeach tranche of securities offered to investors or, in the case of CardsABS, a five percent “seller” interest in the trust assets;

• Periodic third-party verification of compliance with any assetrepurchase provisions for violations of representations in the programmedocumentation;

• Certification by the chief executive officer of the depositor at the time of eachoffering that the asset pool is reasonably expected to generate cash flowssufficient to service the issuer’s liabilities; and

• Periodic reports by the issuer under the U.S. Securities Exchange Actof 1934, as amended (the “Exchange Act”), are required for as long as theissued securities are outstanding (rather than only for one year,as presently).

n Each public offering of asset-backed securities under a programme using“shelf” registration will have to be made using a single prospectus containingall material information relating to each individual issuance, other than pricing-dependent information. This prospectus must be provided to investors not lessthan five business days prior to any sale of the securities. Offerings by mastertrusts backed by non-revolving assets, such as traditional residential mortgageloans, will not be eligible for shelf registration.

n Two new forms of “registration statement” (i.e., the document containingthe prospectus and other disclosure required to be publicly filed with theSEC) will be introduced exclusively for asset-backed securities issued in thepublic markets by both U.S. and non-U.S. issuers, and these forms willcontain significantly expanded disclosure requirements. Issuers of structuredfinance products that do not meet the SEC’s definition of “asset-backedsecurity” such as CDOs will still be required to use the traditional forms ofregistration statement.

n Broker-dealers in public deals will be required to wait for at least 48 hoursbetween the distribution of any prospectus to investors and confirming sales.

11 New Horizons


The issuer would also be required todisclose whether an independent thirdparty had given an opinion to the trusteeconfirming that any such assets that hadnot been repurchased did not in factviolate a representation or warranty and,in certain circumstances, whether theoriginator has made a representation thatthere was no fraud in the origination ofthe assets.

Financial information of the party requiredto repurchase a pool asset for breach ofa representation and warranty pursuantto the transaction agreements will berequired, including the interest of thatparty in the securitisation. Financialinformation in respect of an originator willalso be required.

Prospectus summary requirements

The SEC’s proposals will requireprospectus summaries to concentrateon the variances that are material to thespecific securities described in theprospectus. The ABS Release containsprovisions requiring prospectussummaries to include statisticalinformation relating to the types ofunderwriting or origination programmes,exceptions to the underwriting ororigination criteria and, whereappropriate, modifications to poolassets after origination.

In our view, it is likely that prospectussummaries will be the part of theprospectus which changes the most asa result of the disclosure reformsproposed in various jurisdictions, as theBank of England has set out a list ofinformation it proposes to require to bepresent in the summary section and theEuropean Commission has also set outproposals for the “key information”which must be included in a prospectusthat is compliant with the EuropeanProspectus Directive.

Enhanced static pool disclosure

The SEC in the ABS Release has proposednew disclosure requirements regardingstatic pool information.

Non-U.S. issuers have historically found itdifficult to provide static pool data. Theharmonisation of disclosure in the publicand private markets, if the proposals areadopted, will make it very difficult to avoidpreparing, and providing to investors,static pool data so we anticipate thatnon-U.S. issuers will continue to find theprovision of this data challenging.

Pool-level information

In addition to the requirements for loan-level data, the proposals also seek toenhance the pool-level informationtraditionally provided in most offeringdocuments including:

n disclosure of deviations from thedisclosed origination standards andthe amount of affected assets.

n disclosure of the verification undertakenby the originator of information used inthe solicitation, credit-granting orunderwriting of the pool assets.

n disclosure of the provisions inthe transaction agreementsgoverning modification of the assets.

Other disclosure requirements thatrely on credit ratings

The ABS Release would eliminatecertain existing exceptions to disclosurerules, which are based on investmentgrade ratings.

New registration procedures andforms for Asset-Backed Securities

New forms SF-1 and SF-3

The ABS Release proposes two newforms of registration statement, to be usedby issuers of asset-backed securities:Form SF-1 for stand-alone transactionsand Form SF-3 for shelf programmes.

New shelf eligibility criteria

Currently, the eligibility of asset-backedsecurities programmes for shelfregistration is based in part on whetherthe securities to be issued wouldreceive an investment grade rating froman NRSRO. Under the proposals in theABS Release, the ratings-basedeligibility criterion will be eliminatedand replaced by the following fournew criteria:

n “Skin-in-the-Game”: Thesponsor will be required to retain fivepercent of the risk of thesecuritisation on an ongoing basis,net of the sponsor’s hedging.

The impact of this requirement on non-U.S. issuers will turn on where theissuer is based and how their homejurisdiction capital and asset-transferrules are being applied. We wouldanticipate that, in the UK and in manyother jurisdictions, Cards ABS wouldnot be significantly affected becausethis asset class is issued primarilythrough master trusts that generallyhave seller interests at or above fivepercent. This standard will not berelevant to many non-U.S. issuers of

“Non-U.S. issuers, particularly smaller issuers, may beconcerned about taking responsibility for the waterfallcomputer programme, especially where, historically, thetransaction “model” may have been prepared by thearranger on behalf of the issuer”

New Horizons 12


traditional RMBS since non-revolvingassets such as mortgages would not bepermitted to use the shelf registrationchannel under the proposals.

n Originator buy-back complianceopinion: The party required torepurchase pool assets for breach ofrepresentations and warranties willalso be required to furnish toinvestors, at least quarterly, an opinionof an independent third-party as towhether the obligated party actedconsistently with the terms of therelevant transaction documents, withrespect to any loans that the issuer orthe trustee put back to the relevantparty for violation of representationsand warranties and which were notrepurchased or replaced by theobligated party.

Implementation of this requirement willinvolve additional administration andexpense. It is also not clear who willperform the verification role as the ABSRelease states that audit firms in the U.S.have already indicated that this sort ofopinion would not be within the scope oftheir professional responsibilities. Further,because there are likely to be relativelyfew non-U.S. issuers using shelfregistration, there may be few serviceproviders focusing on helping issuersoutside of the U.S. meet this requirement.

n CEO certification: The chief executiveofficer of the depositor will berequired to file a certification at thetime of each issuance utilising a shelfregistration statement that theassets in the pool havecharacteristics that provide areasonable basis to believe that theywill produce, taking into accountinternal credit enhancements, cashflows to service any payments dueand payable on the securities asdescribed in the prospectus.

This requirement is similar to therequirement in the European ProspectusDirective which requires issuers of asset-backed securities to make a statement inthe prospectus that the assets backing theoffered securities “have characteristics thatdemonstrate the capacity to producefunds to service any payments on thenotes issued”.

n Exchange Act peporting: Theproposals would also require theissuer to undertake to file ExchangeAct reports so long as non-affiliates ofthe depositor hold any securities thatwere sold in registered transactionsbacked by the same pool of assets.

This element of the proposal would requirenon-U.S. issuers to prepare servicerassessments and obtain auditorattestations under Item 1122 of RegulationAB for the life of the transaction.Preparation of these assessments andobtaining the attestations has proved verytime-consuming for non-U.S. issuers, andthis requirement may further discourageeligible non-U.S. issuers from utilising shelfregistration unless the benefits of shelfregistration can be clearly shown tooutweigh the challenges of being subjectto Item 1122 for the life of the programme.

Shelf offerings - formal requirements

Under proposed new rules the issuerwould be required to file a preliminaryprospectus that contains all transaction-specific information about the proposedoffering except very limited pricinginformation, such as the offeringprice/coupon and underwriting discount,at least five business days in advance ofthe first sale of securities in the offering,This five-day period is intended by theSEC to give investors sufficient time toanalyse the transaction and loan-leveldata and run their own scenario analysiswith the waterfall computer programme.

As a consequence, the proposals wouldresult in each they offering being made onthe basis of a single prospectus, rather thanthe existing base-and-supplement format.

Non-U.S. issuers will need to focus onthe implications of being required to usea single prospectus in the U.S., ratherthan a base prospectus and supplementand/or final terms document. If investorsbecome accustomed to receiving a singledisclosure document, we may see morenon-U.S. issuers voluntarily preparingsupplemental prospectuses that areeffectively stand-alone for each offering.

Definition of “Asset-Backed Security”

The exception to the definition of an“asset-backed security” in Regulation ABthat allowed issuers to use shelfregistration for transactions with mastertrust structures, prefunding periods andrevolving periods to allow for changeableasset pools will be amended to preventmaster trust issuers from using non-revolving assets (e.g., mortgages). While“standalone” SEC registration would stillbe theoretically possible, issuers in thissituation would need to determine howthey would comply with the broaderrequirements of Form S-1, or obtainexemptions from these requirements.

Changes will also be made to thepermissible duration of the revolvingperiod of non-revolving assets and theamount of permitted prefunding.

Excluding non-revolving assets frommaster trusts in the definition of “asset-backed security” will make accessing thepublic markets in the U.S. much moredifficult for non-U.S. sponsors ofresidential mortgage master trusts byeliminating the possibility of using the shelfregistration channel and forcing theseissuers to use “old” Form S-1, which wasnot intended for issuers of asset-backedsecurities. Non-U.S. issuers of Cards ABSwill not be affected by these changes.

13 New Horizons


It is not yet clear how the SEC will treatcovered bonds for purposes of thisdefinition. The term “covered bond” doesnot appear in the ABS Release. Whilemost observers are hopeful that the SECwill recognise covered bonds assomething other than “asset-backedsecurities” (or other “structured financeproducts”), and thus outside the scope ofthe proposals contained in the ABSRelease, this is not clear, and the SEC’sfinal view may turn on the structure of thecovered bond programme and the way inwhich the covered bonds are beingmarketed to investors.

Exchange Act reportingThe SEC has expressed concern aboutthe quality of on-going reporting toinvestors in public transactions andproposes several important changesaimed at ensuring investors are madeaware of any material change (i) in theasset pool at issuance to the pool datadisclosed in the prospectus and (ii) inthe sponsor’s interest in theoffered securities.

The exception for ABS transactions fromthe requirement that broker-dealers must

deliver a preliminary prospectus at least48 hours before confirming any sale ofthe relevant securities will be eliminatedfor all offerings of asset-backedsecurities, including those involvingmaster trusts.

Key changes forprivately-issued structuredfinance products The changes affecting the Rule 144Amarket are summarised in the text boxon page 8. This section discusses theimpact of the proposed changes inmore detail. Many of the changes applyequally to offerings under Regulation D.However, the ABS Release seems todistinguish between Rule 144A offeringsand Regulation D offerings, in terms ofrequired on-going disclosure (withspecific requirements for on-goingdisclosure only applicable to Rule 144Aofferings). Therefore, non-U.S. issuersmay want to put greater focus on therequirements of Regulation Dto conduct private offerings in theUnited States. Although issuers ofRegulation D offerings will have to providesimilar information that required to beprovided for Rule 144A.

The ABS Release would introduce adefinition of “structured financeproducts” to which the new proposalswill apply. In addition to traditional“asset-backed securities”, otherproducts including synthetic asset-backed securities and fixed-income orother securities collateralised by anypool of self-liquidating financial assets,such as loans, leases, mortgages andreceivables will be caught. This changeevidences a clear intention on the partof the SEC to close what it perceives asa disclosure “loophole” in theirdisclosure regulation.

If the notice which must be filed with

the SEC within 15 calendar days afterthe first sale of securities in the offering,has not been filed, then Rule 144A willnot be available for subsequent resales.

On their face, the proposals in the ABSRelease apply to offerings of ABCP.Most ABCP sold in the United States isoffered in private placements with verylittle disclosure on underlying poolassets or other matters covered byRegulation AB. However, unlike almostall other types of asset-backedsecurities, ABCP either is, or mayreadily be, sold pursuant to the Section4(2) exemption (which is not covered bythe proposals in the ABS Release, asnoted above). Accordingly, unless theproposals in the ABS Release arerevised to address this point, it ispossible that issuances of ABCP will notfall into the disclosure requirements inthe proposals.

Even if offerings of commercial paper arenot strictly covered by the ABS Release,the enhanced disclosure regime for Rule144A and Regulation D offerings mayeffect a change in “best practice” for thelevel of disclosure in programmedocumentation for ABCP issuers.

The ABS Release can be found at:http://www.sec.gov/rules/proposed/2010/33-9117.pdf.

“Even if offerings ofcommercial paper are notstrictly covered by the ABSRelease, the enhanceddisclosure regime for Rule144A and Regulation Dofferings may effect achange in “best practice”for the level of disclosure inprogramme documentationfor ABCP issuers”

http://www.sec.gov/rules/proposed/2010/33-9117.pdf


New Horizons 14


ConclusionFrom its broad scope and innovative provisions, the ABS Release represents the most significant governmental initiative in theU.S. to date in the area of regulation of the securitisation markets. The requirement that effectively all investors in structuredfinance products receive loan-level data accompanied by a bespoke computer model has the potential to revolutionise thesecuritisation markets in the U.S. and around the world. In addition, by harmonising disclosure in the public and private markets,the SEC sends a strong signal that they expect a greater degree of integrity and “best practice” in the offering and sale of asset-backed securities.

The proposals in the ABS Release have the potential to benefit non-U.S. issuers of ABS and other structured products if theyincrease investor confidence resulting in the restoration of a vibrant market for these products in the U.S.

At the same time, these potential benefits will come with a not insignificant cost as non-U.S. issuers will seek to adapt to thenew requirements and harmonise them with other regulatory initiatives to which they may also be subject in their homemarkets. In addition, non-U.S. issuers are also currently grappling with the implications of the SEC’s separate Rule 17g-5,effective 2 December 2010 (following the recently granted temporary exemption), which regulates conflicts of interest atNRSROs but which places significant burdens on arrangers of asset-backed securities offerings where there is a rating from atleast one NRSRO which is paid for by the arranger.

Market participants and other observers will be keenly following the comment process on the ABS Release with the SEC over thenext several months for signs of the level of acceptance of these proposals and the chance that they will either be adopted largelyin their current form or, alternatively, substantially revised prior to adoption. The degree of take-up of the proposals in the U.S.may also signal whether the ideas proposed by the SEC in the ABS Release wind up setting global standards for the industry.

3. SEC’s proposed changes toRegulation AB will significantlyimpact U.S. private structuredfinancings


If adopted in substantially its currentform, the ABS Release would have awide-ranging impact on participants inthe asset-backed securities markets inthe United States. One of the principalaspects of the ABS Release is that theSEC proposes to require, for the firsttime in connection with registered ABSofferings, disclosure of asset-level datafor each asset comprising the pool ofassets in an ABS, in addition to thepool-level data already required byRegulation AB in its current form. TheSEC also proposes to refine existing,and require additional, pool-level datadisclosure obligations in connection withregistered ABS offerings, in order toenhance the information available toanalyse a pool.

With respect to the private ABS market,in the ABS Release the SEC stated that,in its view, investors in many cases didnot have the information necessary tounderstand and properly analysestructured products, such ascollateralised debt obligations (“CDOs”),that were sold in transactions in relianceon exemptions from SEC registration. Asa result, to address these and otherconcerns, the SEC is proposingsignificant revisions to the safe harboursavailable for resales under Rule 144A(“Rule 144A”) under the Securities Actand for exempt offerings under Rule 506(“Rule 506”) of Regulation D under the

Securities Act, in order to requirespecific disclosures in private offerings ofstructured finance products, as well asadditional public information about suchprivate offerings.

The proposals were published in theU.S. Federal Register on 3 May 2010(available at http://edocket.access.gpo.gov/2010/pdf/2010-8282.pdf) andare subject to a 90-day public commentperiod, scheduled to expire on 2 August2010, during which industry participantsmay submit comments to the SEC. Asubstantial volume of comments islikely. Following the public commentperiod, the SEC may revise theproposals in response to the commentsreceived. The SEC may choose toadopt some or all of the proposalscontained in the ABS Release.Alternatively, the SEC may choose to re-propose portions of the proposals if itfeels that there are sufficientlymeritorious objections fromcommentators to portions of the originalproposal to warrant re-consideration.

At this time, it is difficult to forecastwhether or when some or all of theproposals will come into effect. If adopted,the provisions of the ABS Release willformally apply only to asset-backedsecurities and other structured financeproducts offered or sold in the U.S. afterthe effective date set by the SEC forimplementation of the proposals.However, we expect that prior toadoption, the proposals will prompt theestablishment of various new “bestpractices” in the securitisation markets inthe U.S. and possibly elsewhere. Further,the various proposals may start to shapeinvestor expectations well before anyformal effectiveness.

This memorandum focuses on thepotential impact of the current proposalson asset-backed securities and otherstructured finance products offered orsold in the United States under theprivate offering exemptions mostcommonly used for such products – Rule144A and Rule 506.1 We identifyquestions that have emerged as a resultof the ABS Release and suggest certain

On 7 April 2010, the U.S. Securities and Exchange Commission (the “SEC”)published sweeping proposals to update and expand the regulation of offerings ofasset-backed securities in the United States in both the public and, for the first time,the private markets. The proposals (Release Nos. 33-9117; 34-61858; File No. S7-08-10, the “ABS Release”) would involve substantial revisions to Regulation AB(“Regulation AB”) under the U.S. Securities Act of 1933, as amended (the “SecuritiesAct”), and other U.S. rules and regulations regarding the offering process, disclosureand ongoing reporting for asset-backed securities (“ABS”) and other structuredfinance products.

New Horizons 16

“Issuers of asset-backed securities or other structuredfinance products in most U.S. privatetransactions…will be required to undertake toprovide…the same level of information as would berequired in an SEC-registered transaction”

1 References herein to “exempt private offerings” refer only to offerings conducted in reliance on the safe harbours available under Rule 144A and Rule 506, which are the mostcommon offering exemptions used for ABS offerings in the private markets and which are directly affected by and addressed in the ABS Release.

http://edocket.access.gpo.gov/2010/pdf/2010-8282.pdf

http://edocket.access.gpo.gov/2010/pdf/2010-8282.pdf

potential best practices that may (orshould) develop among participants inthe private ABS market in light of theSEC’s expressed views and thepossibilities of passage of the variousproposals within the ABS Release.

Highlights of New DisclosureRequirements Affecting Non-Public OfferingsThe ABS Release contains a number ofproposed regulatory changes designedto increase transparency for investors inthe U.S. securitisation markets andreduce, and potentially even eliminate,reliance on nationally recognisedstatistical rating agencies (“NRSROs”).However, the ABS Release would alsosignificantly expand the obligations ofissuers and distributors of asset-backedsecurities. Highlights of the proposalscontained in the ABS Release thatimpact (or will likely impact) the privateasset-backed securities market includethe following:n Issuers of asset-backed securities or

other structured finance products inmost U.S. private transactions(including foreign issuers conductinga Rule 144A offering alongside aseparate non-U.S. offering) will berequired to undertake to provide,promptly upon request by anyprospective purchaser of thesecurities, the same level ofinformation as would be required inan SEC-registered transaction. Inaddition, for Rule 144A offerings, theissuer will be required to file anotification of the issuance ofstructured finance products with theSEC, setting out specifiedinformation about the offeredsecurities and the underlying assets,within 15 days after the first sale ofsecurities in the offering. This issimilar to the filing that is currently

required for offerings relying uponRule 506 (which would also beamended to apply to structuredfinance products).

• Significantly enhanced “loan-level” disclosure will be requiredon each of the underlying poolassets securing a structuredfinance product, with specificdata fields identified by the SECfor 11 different asset types(although use of grouped datawould be permitted for creditcard ABS).

• The required loan-level data will berequired to be filed with the SEC incomputer-readable form, togetherwith a computer programmebased on the “waterfall” containedin the transaction documents thatpermits an investor to run its ownanalysis of the assets and thecash flows (the “waterfall computerprogramme”).

• An issuer will be required toprovide historical data with respectto assets that have been “putback” to the sponsor or originatorfor breaches of point-of-salerepresentations and warranties.

n The possibility that newrequirements proposed in the ABSRelease could lead to paralleladoption in certain private ABSmarkets of public-marketprocedures, including (i) the use of asingle prospectus containing allmaterial information (other thanpricing-dependent information)similar to the single-prospectusrequirement for shelf offerings (thuseliminating the option of public ABSissuers to use a base, orprogramme, prospectus and atransaction-specific prospectussupplement for each individual

issuance), and (ii) the delivery toinvestors of a disclosure documentat least five business days prior toany sale of an asset-backed security.

New Conditions forOfferings Relying on Rule144A and Rule 506The ABS Release, if adopted, would forthe first time require that an issuer makeavailable disclosure in the private Rule144A and Rule 506 markets that isconsistent with that required in the U.S.public markets, effectively eliminatingthe flexibility of transaction parties toindependently determine appropriatedisclosure based upon what informationmay or may not be material in thecontext of a particular transaction. Thisaspect of the proposal represents amajor change from prior practice andreflects a clear intention on the part ofthe SEC to close what it perceives as agap in existing disclosure regulation.

Specifically, the SEC is proposing tomake the availability of the safe harboursprovided by Rule 144A and Rule 506conditional on a requirement that, if thesecurity offered or sold is a “structuredfinance product” within the meaning ofthe ABS Release, the underlyingtransaction agreements would have togrant any securities purchaser the right toobtain from the issuer promptly, uponrequest by the purchaser, suchinformation as would be required if theoffering were registered on Form S-1 ornew Form SF-1 (for non-shelf offerings ofABS), as applicable, under the SecuritiesAct. In addition, the issuer must representin that transaction agreement that it willprovide such information upon request.An issuer’s failure to actually provide therequired information would give rise topotential breach-of-contract claims, aswell as the potential for SEC enforcement


17 New Horizons


New Horizons 18

action against the issuer pursuant toproposed Rule 192, but would not, ineither case, retroactively disqualify theissuer’s compliance with the applicablesafe harbour.

The ABS Release would introduce adefinition of “structured finance product”which would include, in addition totraditional “asset-backed securities” (asdefined under Item 1101(c) of currentRegulation AB), synthetic asset-backedsecurities and any “fixed-income orother security collateralized by any poolof self-liquidating financial assets, suchas loans, leases, mortgages, andsecured or unsecured receivables thatentitles its holder to receive paymentsthat depend on the cash flow from theassets.” This includes “a collateralizedmortgage obligation, a collateralizeddebt obligation, a collateralized bondobligation, a collateralized debtobligation of asset-backed securities, acollateralized debt obligation ofcollateralized debt obligations,” or asecurity that at issuance is “commonlyknown as an asset-backed security or astructured finance product.” This broaddefinition is designed at least toencompass certain managed ABS, and,since there is no requirement of having a“discrete pool of assets,” would alsogenerally encompass all managedstructure finance products.

Effect on private market: In light of thebroad definition of “structured financeproduct” (which the ABS Releasespecifically states encompassesmanaged CDOs), sponsors andmanagers of private managed fundsshould begin to consider what are thedistinguishing features of those funds thatplace them outside the scope of thedefinition of “structured finance

products.” Depending on the structure ofthe particular private managed fund,inclusion under the rules may hinge onnarrow distinctions (such as the meaningof the word “collateralized” within thedefinition of “structured finance product”).

With respect to Rule 144A, the scope ofthe information that could be requestedalso includes ongoing informationregarding the securities that would berequired by Section 15(d) of theSecurities Exchange Act of 1934, asamended (the “Exchange Act”), if theissuer were required to file reports underthat section, and the right to obtain thespecified information would extend to anyinitial purchaser, any security holder orany prospective purchaser designated bya security holder.

Effect on private market: UnderExchange Act Section 15(d), for anissuer that does not otherwise have aclass of securities registered under theExchange Act, the duty to file ongoingreports is automatically suspended afterthe first year if the securities of eachclass to which the registration statementrelates are held of record by less than300 persons.2 The ABS Release doesnot expressly address whether, by virtueof Exchange Act Section 15(d), an issuerof a “structured finance product” thatrelied on the Rule 144A safe harbourcould suspend its ongoing reportingobligations after it makes availableinformation equivalent to that whichwould otherwise be contained in its firstannual report, as long as the issuer hasless than 300 record holders and doesnot also have a class of securitiesregistered under the Exchange Act. Weexpect that this particular question willbe clarified during or following the publiccomment process.

The end-result of these disclosure ruleswould be to harmonise disclosure levelsin the public and private ABS markets,allowing investors in an exempt privateoffering of a structured finance product toreceive substantially the same level ofdisclosure as in a registered offering.

New Disclosure Requirements

Proposed Asset-Level ReportingRequirements

Under the proposals in the ABSRelease, a public issuer would berequired to include detailed asset-leveldata both in the prospectus at the timeof initial offering and in ongoingExchange Act reports. This asset-leveldata would have to be provided in astandardised, computer-readable formatfiled on EDGAR (the SEC’s electronicsystem for data submission) at the timeof issuance, whenever new loans orother assets are added to the poolunderlying the securities, and on anongoing basis in periodic reportspursuant to Section 13 andSection 15(d) of the Exchange Act.

The ABS Release establishes generaldata points, as well as asset-class-specific data points for 11 specific assetclasses (residential mortgages,commercial mortgages, auto loans, autoleases, equipment loans, equipmentleases, student loans, credit cards,floorplan financings, corporate debt andresecuritisations) that would be requiredto be disclosed for each asset in a pool.Further, the ABS Release states thatresecuritisations issued after theimplementation date of the ABS Releasewould also be subject to the newrequirements, regardless of whether theissuance of the resecuritisation’sunderlying securities predates theimplementation date.

2 As noted in the ABS Release, typically the reporting obligations of asset-backed issuers (other than those with master trust structures) under Exchange Act Section 15(d) aresuspended after they have filed one annual report because the number of record holders of each class of its securities is below the 300-record-holder threshold.

19 New Horizons


Effect on private market: Given theabsence of grandfathering forresecuritisations having underlyingsecurities that were issued prior to theABS Release’s implementation date,sponsors of such resecuritisations inexempt private offerings should begin todetermine the type and level ofdisclosure that would satisfy disclosureobligations under the ABS Release (ifadopted in its current form) with respectto an asset-backed security underlying aresecuritisation. A sponsor should plannow its disclosure procedures for anyasset-backed security to be resecuritisedin the future. In certain cases a privateresecuritisation sponsor may wish toexpedite resecuritisations contemplatedfor the near (and possibly intermediate)term so as to achieve completion prior tothe effectiveness of any final proposal.Meanwhile, resecuritisation sponsorsshould consider the other issues raisedbelow regarding the appropriate asset-level disclosure for private offerings inthe interim.

With respect to each individual asset in apool (or, in a credit card ABS, each groupof assets), the issuer would be required toprovide specified data, including the termsof the asset, obligor characteristics,interest rates and primary servicerinformation. Issuers would also berequired to update the asset-level data forchanges to the pool prior to the date onand after which collections on the poolassets accrue for the benefit of the ABSholders (the “cut-off date”), if the initialdata is from an earlier date. These datapoints would include the current assetbalance, the number of days the obligor isdelinquent, the number of payments theobligor is past due as of the cut-off dateand the remaining term to maturity.

Credit card ABS issuers would be exemptfrom the foregoing asset-level data

disclosure obligations, but would insteadbe required to disclose grouped accountdata in the same standardised format.

Effect on private market: Given thedetailed asset-level disclosures requiredby the ABS Release, issuers in certainkinds of exempt private ABS offeringswill need to balance their Securities Actdisclosure obligations with anyconfidentiality restrictions that may applyto certain information about thoseassets. Although the ABS Releaseenvisions disclosures to be in ranges orcategories of coded responses toattempt to address this concern, a moregranular focus is required to assesspermissible disclosure for each datapoint of each asset class where theseand other privacy concerns are present.

Although the changes in the ABSRelease as proposed will not applyretroactively upon becoming effective, inview of the considerable focus in theABS Release on asset-level disclosure,an issuer in an exempt private ABSoffering should consider now what, ifany, additional asset-level disclosure isappropriate to meet its disclosureobligations for securities law purposes.Similarly, consideration should be givento implementing other types ofdisclosures that the ABS Release wouldrequire for registered ABS offerings,including the waterfall computerprogramme, disclosures relating totransaction parties, and static poolinformation. Even issuers of structuredfinance products in private placementsrelying directly on Section 4(2) or

“Section 4(1½)” of the Securities Actshould consider the effect of these(and other) provisions of the ABSRelease on their disclosure obligationsand practices.

While issuers in public offerings of ABSin the U.S. would be required to file therelevant asset data (the “asset datafile”) on Form 8-K at various timesduring the offering process, includingwhen a prospectus (both preliminaryand final) is filed with the SEC andwhen updating disclosure is otherwiserequired, the ABS Release does notstate that issuers in exempt privateofferings of ABS will have to file theasset data file (though it is expectedthat they would be required to make itotherwise available).

If an SEC registrant experiencesunanticipated technical difficulties thatprevent the timely preparation andsubmission of an asset data file, thesubmission would still be consideredtimely if the asset data is posted on awebsite on the same day it was due tobe filed on EDGAR, the websiteaddress is specified in the requiredexhibit, a legend is provided in theappropriate exhibit claiming thehardship exemption, and the asset datafile is filed on EDGAR within sixbusiness days.

Waterfall Computer Programme

Issuers of public asset-backed securitieswould be required to file on EDGAR acomputer programme (the “waterfallcomputer programme”) that gives effect

“An issuer in an exempt private ABS offering shouldconsider now what, if any, additional asset-leveldisclosure is appropriate to meet its disclosureobligations”

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to the contractual cash flow provisions ofthe securities in the form of downloadablesource code in “Python”, which the SECnotes (in the ABS Release) is a commonlyused open source and interpretivecomputer programming language.

The filed source code for the waterfallcomputer programme would have toprovide a user with the ability to inputits own assumptions regarding thefuture performance and cash flows fromthe pool assets, including assumptionsabout future interest rates, defaultrates, prepayment speeds, loss-given-default rates, and any otherassumptions currently required to bedescribed under Item 1113 ofRegulation AB, in order to facilitate andbetter enable the investor to conductits own evaluations. The waterfallcomputer programme would berequired to allow the user to integratethose assumptions with the asset datafile that the issuer must make availableat the time of the offering and on aperiodic basis thereafter.

The waterfall computer programmewould also be required to produce aprogrammatic output, in machine-readable form, of all resulting cash flowsassociated with the offered securities(including the amount and timing ofprincipal and interest payments payableor distributable to a holder of each classof securities), and each other person oraccount entitled to payments ordistributions in connection with thesecurities, until the final legal maturitydate, all as a function of the inputsentered into the waterfall computerprogramme. The issuer would berequired to file with the SEC an exampleof the expected output for each tranchebased on sample inputs entered intothe waterfall computer programme.

Like the asset data file, the waterfallcomputer programme would be anintegral part of the prospectus, as anissuer would be required to provide thewaterfall computer programme at thetime of filing a preliminary prospectus,with data accurate as of the filing date.Similarly, the waterfall computerprogramme would be required to befiled with the final prospectus, with dataaccurate as of that date of filing. AnSEC registrant would be entitled to ahardship exemption similar to thatdescribed above.

Effect on private market: Becausea waterfall computer programmewould very likely be part of the marketingmaterials provided to prospectiveinvestors in exempt private offerings,initial purchasers in Rule 144A offerings,and placement agents in Rule 506offerings, of structured finance products,which would otherwise have to be filedunder new Form SF-1 if offered publicly,should consider what type and level ofdue diligence would need to beconducted with respect to the waterfallcomputer programme.

In addition, regardless of who logisticallyconstructs or designs the waterfallcomputer programme, an issuer of astructured finance product willnevertheless face significant ultimateexposure and potential liability for thewaterfall computer programme, andtherefore must perform a proactive rolein developing and understanding thewaterfall computer programme,irrespective of any proactive roleperformed by its underwriter orplacement agent or its accountants.

Matters Relating to Transaction Parties

Identification of Originator

Regulation AB currently provides that anyparty that has originated 10% or more of

the assets underlying a transaction mustbe treated as an originator, even if thatentity is not affiliated with the issuer orthe sponsor. The SEC has expressedconcern that this may result in minimaldisclosure about originators where asubstantial part of the underlying assetscomes from third-party originators but nosingle originator represents more than10% of the asset pool.

To address this concern, the ABSRelease would identify an entity as anoriginator even if it originated less than10% of the pool assets, if the cumulativeamount of originated assets by partiesother than the sponsor (or its affiliates)comprises more than 10% of the totalpool assets.

Effect on private market: This newproposal could limit the attractiveness,feasibility or economic viability of an assetmanager accumulating pools of third-party-originated assets with a view tosecuritisation.

Expanded Disclosure Regarding Historyof Assets Repurchased

The ABS Release proposes newdisclosure relating to a sponsor’sperformance history with respect toasset-level warranties. Specifically, anissuer would be required to disclose on arolling three-year basis the amount, ifmaterial, of securitised assets originatedor sold by the sponsor or an identifiedoriginator that were “put back” to thesponsor or originator for repurchase as aresult of a breach of any point-of-salerepresentation and warranty. Thisdisclosure would be provided on a pool-by-pool basis, together with thepercentage of such assets that had notthen been repurchased or replaced bythe sponsor or originator.

21 New Horizons


Effect on private market: Sincedisclosures relating to the history of “putbacks” are proposed to cover a rollingthree-year look-back period, as well ascontain a breakdown of the amount ofassets that were subject to “put back”requests but were not repurchased orreplaced, issuers of ABS in exemptprivate offerings should ensure they have(or take necessary steps to obtain)operational and technical capacity toprovide such information.

The issuer would also be required todisclose whether an independent thirdparty had given an opinion to the trusteeconfirming that any such assets that hadnot been repurchased did not in factviolate a representation or warranty.

Financial information about the partyrequired to repurchase a pool asset uponbreach of a representation and warrantypursuant to the transaction agreementswould also be required, includinginformation about the interest of thatparty in the securitisation. For example,information regarding the financialcondition of an originator that accountsfor 20% or more of the pool assets wouldbe required if there is a material risk thatits financial condition could have amaterial impact on the origination of itsassets in the pool or on such originator’sability to comply with its repurchaseobligations (“put-backs”) for those assets.Information regarding the sponsor’sfinancial condition would similarly berequired to the extent that there is amaterial risk that its financial conditioncould have a material impact on its abilityto comply with its repurchase obligationsfor those assets or could otherwisematerially impact the pool.

In addition, for public offerings registeredon Form SF-1, the issuer would berequired to provide clear disclosure

that the sponsor is not required by law toretain any interest in the securities andmay sell any interest initially retained atany time.

Prospectus Summary Requirements

The SEC in the ABS Release expressedconcern that existing prospectussummaries for ABS tend to describestructural features that are common toall securitisations of a particular assetclass, rather than concentrating on thevariances that might be material to thespecific securities described in theprospectus. The ABS Release containsprovisions requiring prospectussummaries to include statisticalinformation relating to the types ofunderwriting or originationprogrammes, exceptions to theunderwriting or origination criteria and,where appropriate, modifications to poolassets after origination.

Effect on private market: Issuers inexempt private offerings should plan toadjust private offering disclosure toconform with the public disclosurerequirements being proposed. Care willneed to be exercised, however, inassessing whether particularrequirements conflict with confidentialityrestrictions under law or contract or callfor commercially sensitive information.For example, it is unclear under thisrequirement how much detail anoriginator would have to provide aboutloans that did not meet its underwritingcriteria. Identifying such loans maybreach confidentiality provisions anddisclosure of certain deficiencies may becommercially sensitive.

Enhanced Static Pool Disclosure

The current version of Regulation ABintroduced the idea of providing investorswith historic pool information on a “static”basis. The SEC in the ABS Release has

proposed four new disclosure requirementsregarding static pool information to be filedon EDGAR:

n narrative disclosure describing thestatic pool information presented;

n a description of the methodologyused in determining or calculating thecharacteristics and a description ofany terms or abbreviations used;

n a description of how the assets in thestatic pools shown in the prospectusdiffer from the pool assets underlyingthe securities being offered; and

n if an issuer does not include staticpool information or includesdisclosure that is intended to serve asalternative static pool information, anexplanation of why that issuer has notincluded static pool disclosure or whyit has provided alternative information.

Static pool information related todelinquencies, losses and prepaymentswould also need to be presented foramortising asset pools.

Effect on private market: Whereas,since the adoption of the existingRegulation AB, market practice withrespect to most (if not all) asset classesof the exempt private ABS market hasbeen to not include static poolinformation, under the ABS Release (asproposed) issuers of ABS in exemptprivate offerings would be required toprovide enhanced static poolinformation and would thus need toconsider how to comply with thisrequirement for each type ofasset class.

Pool-Level Information

Deviations from Underwriting Standards

The issuer’s disclosure regarding theunderwriting of assets that deviate fromthe disclosed origination standards (forexample, assets that are past due at

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the time of inclusion) must beaccompanied by specific data aboutthe amount and characteristics ofthose assets that did not meet thedisclosed standards.

To the extent that disclosure is providedregarding compensating or other factors,if any, that were used to determine thatthe assets should be included in thepool, despite not having met thedisclosed underwriting standards, theissuer would be required to specify thefactors that were used in thatdetermination and provide data on theamount of assets in the pool that arerepresented as meeting those factors.An example would be when a very lowloan-to-value ratio for a particularresidential mortgage loan is consideredby the originator to offset a poor creditscore on the part of the borrower.

Verification Methods

The issuer would be required todisclose what steps were undertaken bythe originator(s) to verify the informationused in the solicitation, credit-grantingor underwriting of the pool assets.

Modification of Assets

The issuer would be required to includedisclosure of the provisions in thetransaction agreement(s) governingmodification of the assets, disclosureabout how modification may affect cashflows from the assets or to thesecurities and disclosure of whether ornot a fraud representation is includedamong the representationsand warranties.

Effect on private market: To theextent an asset accumulator or assetmanager purchases assets in thesecondary market with an intent tosecuritise, it may not have access to the

relevant data from the originator(s) ofthose assets. As such, it is not clear howan asset accumulator or asset managermaking such secondary marketpurchases would comply with these newdisclosure requirements under thosecircumstances.

Other Disclosure Requirements that Relyon Credit Ratings

The ABS Release would eliminateexisting exceptions to disclosure ruleswhich are based on investment graderatings, including:

(1) removing an instruction to Item1112(b), which provides that nofinancial information regarding asignificant obligor is required if theobligations of the significant obligorare backed by the full faith andcredit of a foreign government andthe pool assets are securities thatare rated investment grade by aNRSRO; and

(2) removing an instruction to Item 1114which relieves an issuer of theobligation to provide financialinformation when the obligations ofthe credit enhancement provider arebacked by a foreign government andthe enhancement provider has aninvestment grade rating.

Effect on private market: It will benecessary to add correspondingdisclosure in exempt private offerings ofasset-backed securities and otherstructured finance products. While therequirements proposed for offeringsrelying on Rule 144A and Rule 506 arenot contemplated to apply expressly toother types of private offerings, marketparticipants must consider the degree, ifany, to which an analogous andsimilar approach should be used insuch offerings.

Issues Regarding “WaitingPeriod” and Format ofOffering DocumentsThe SEC has expressed concern thatshelf programmes generally may haveconfused investors or presented a lowerlevel of disclosure than stand-aloneofferings, because the disclosurerelating to the securities is split betweena base, or programme, prospectus anda transaction-specific prospectussupplement for each individualissuance. Specifically, in the ABSRelease the SEC stated that the use ofa base prospectus with a prospectussupplement has resulted in “unwieldydocuments with excessive andinapplicable disclosure that is not usefulto investors.” To address theseconcerns, the SEC has proposed newRule 424(h) and Rule 430D as aframework for shelf offerings of asset-backed securities.

With respect to each offering, proposedRule 430D would require substantially allof the information that was omitted fromthe form of prospectus (except forpricing-dependent information) to be filedwith the SEC at least five business daysin advance of the first sale of securities inthe offering in a preliminary prospectusthat must be in near-final form. As aconsequence, the proposals would resultin each offering being made on the basisof a single prospectus, rather than theexisting base-and-supplement format.

Effect on private market: As a resultof this proposal, issuers of ABS inexempt private offerings may shifttowards use of a single offeringdocument and discontinue the use of abase offering documentplus supplement.

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Consistent with current practice, underthe proposals, the form of prospectuswhich would be contained in a Form SF-3 shelf registration statement maycontinue to omit any transactionstructure or asset- or pool-specificinformation or data at the time it isdeclared effective by the SEC. However,under proposed new Rule 424(h), theissuer would be required to file apreliminary prospectus (a “Rule 424(h)filing” or “Rule 424(h) prospectus”) thatcontains all transaction-specificinformation about the proposed offering(except pricing-dependent information)at least five business days in advance ofthe first sale of securities in the offering.This five-business-day period is intendedby the SEC to give investors sufficienttime to analyze the transaction and loan-level data and run their own scenarioanalysis using the waterfall computerprogramme. If the preliminaryprospectus is used earlier than suchfive-business-day period to offer thesecurities, the ABS Release wouldrequire it to be filed by the secondbusiness day after first use.

Effect on private market: In light ofthis proposed five-business-day waitingperiod in registered shelf offerings, ABSissuers in exempt private offerings shouldconsider implementing a similar waitingperiod between the distribution toinvestors of a preliminary offeringdocument and delivery of a finaloffering document.

Proposed Rule 430D would also providethat a material change in the informationprovided in the Rule 424(h) filing (otherthan pricing-dependent information),would require a new Rule 424(h) filing andconsequently a new five-business-daywaiting period.

Effect on private market: In light ofthis proposal, ABS issuers in exemptprivate offerings should consider using asimilar waiting period in circumstanceswhere there have been material changesto a final offering document from thepreliminary offering document. Issuers ofstructured finance products in privateplacements relying directly on Section4(2) or “Section 4(1½)” of the SecuritiesAct should consider implementingprocedures similar to those noted abovewith respect to waiting periods.

Similarly, the ABS Release eliminates theexemption for shelf-eligible ABSofferings from the so-called 48-hour rule,which requires a broker or dealer todeliver a preliminary prospectus to anyperson at least 48 hours before suchperson is sent a confirmation.

The ABS Release can be found at:http://www.sec.gov/rules/proposed/2010/33-9117.pdf.

ConclusionBeyond its effects on the public ABS markets, if adopted in its current form the ABSRelease will have a significant impact on exempt private offerings of asset-backedsecurities and other structured finance products that are conducted in reliance on thesafe harbours provided by Rule 144A and Rule 506 of Regulation D. The ABSRelease would require substantially more disclosure in such offerings than is currentlythe market practice. The ABS Release is also likely to affect disclosure practices usedby market participants in other types of private offerings of asset-backed securitiesand other structured finance products, such as private placements relying directly onSection 4(2) or “Section 4(1½)” of the Securities Act. By seeking to harmonisedisclosure in the public and exempt private markets, the SEC in the ABS Releasesends a strong signal that it expects a greater degree of disclosure and other “bestpractices” in exempt private offerings and sales of asset-backed securities and otherstructure finance products.

Participants in the exempt private markets for asset-backed securities and otherstructured finance products will be keenly following the comment process on the ABSRelease over the coming weeks and months for signs of the level of acceptance of theproposals contained therein and the chance that they will either be adopted largely intheir current form or, alternatively, substantially revised prior to adoption. Regardless ofthe outcome, the ABS Release justifies a current re-assessment of U.S. private offeringpractices for structured finance products and is certain to result in fundamentalchanges in U.S. private offerings of structured finance products in the future.




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4. Implications of the SEC Rule17g-5 for structured financetransactions


This release included a controversial newrule (known as Rule 17g-5(a)(3) (the“Rule”)), which was intended by the SECto improve the quality of ratings byincreasing transparency, competition, andaccountability for NRSROs. The Ruleinitially had a compliance date of 2 June2010. This rule-making activity derivesfrom a process that began in June 2008following the start of the financial crisiswhen the SEC proposed numerousamendments to its existing anti-conflictsrules applicable to NRSROs and continuedthrough February 2009, when the SECadopted the majority of these proposalsand also re-proposed Rule 17g-5(a)(3) insubstantially modified form. On 19 May2010, after extensive lobbying, the SECgranted a six month exemption for certainnon-U.S. transactions from therequirements of the Rule.

Substance of the Rule Under the Rule, NRSROs that are hiredby issuers, sponsors, underwriters,arrangers, or originators (each, an“Appointing Party”) to provide creditratings for structured finance productsare required to disclose thesetransactions to other NRSROs whichwere not hired by the Appointing Party toprovide ratings. The hired NRSRO mustprovide a list of each structured financeproduct that it is currently rating on apassword-protected website which otherNRSROs will be able to access.

The Rule prohibits NRSROs from issuingor maintaining credit ratings on certainstructured finance products unlessinformation that is provided to theNRSRO is provided by the AppointingParty to a password protected websitewhich is accessible by other NRSROs.In order to comply with this requirement,NRSROs now require as a term of their

engagement, that the Appointing Partymust represent to the hired NRSRO thatthey will provide all of the informationgiven to the hired NRSRO for thepurposes of issuing an initial credit ratingor undertaking credit rating surveillanceon the Appointing Party to all non-hiredNRSROs through a password-protectedwebsite. The required informationincludes, but is not limited to, thecharacteristics and performance of theassets underlying or referenced by thesecurity or money market instrumentand the legal structure of the security ormoney market instrument.

The password-protected website to bemaintained by the Appointing Party willonly be available to NRSROs that providea certification to the SEC that they will onlyaccess the website to determine ormonitor credit ratings and that all materialsdiscovered through the website will beconsidered non-public and confidential.The non-hired NRSROs can use thisinformation to provide unsolicited creditratings or ratings solicited by subscribinginvestors for the given structured productor transaction. The SEC has stated thatit believes that this process will providean independent check on all creditratings of structured finance productsand will reduce what it believes are theadverse consequences of a small numberof financial institutions paying for themajority of ratings in this area.

One of the key concerns aboutcompliance with the Rule has been thescope of information required to bedisclosed and, in particular, the extentand process in which informationprovided orally to a hired NRSRO mustbe disclosed on the Appointing Party’swebsite. Currently, market participantsbelieve that that they should discloseoral statements containing informationprovided to a hired NRSRO for thepurpose of determining or monitoring itscredit rating, but the parties may nothave to disclose oral communicationsthat are merely operational or logisticalin nature. Clarification by the SEC onthis point would be welcomed bymarket participants.

The hired NRSRO must be able toreasonably rely upon the AppointingParty’s written representation. Factors todetermine reasonable reliance depend onthe facts and circumstances of a givensituation. These would include ongoing orprior failures by the Appointing Party toadhere to its representations or a patternof conduct by the Appointing Party whereit fails to promptly correct breaches of itsrepresentations. The Appointing Party’sfailure to comply with its representationcould lead to the withdrawal of the creditratings paid for by the Appointing Partyand the denial of the ability to obtainfuture credit ratings from the hiredNRSRO. It is the SEC’s view that, going

In November 2009, the U.S. Securities and Exchange Commission (the “SEC”) issueda release1 containing additional rules regarding conflicts of interest at rating agencieswhich have been granted the status of “nationally recognized statistical ratingorganization” by the SEC (each, an “NRSRO”).

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“Currently, market participants believe that that theyshould disclose oral statements containing informationprovided to a hired NRSRO for the purpose ofdetermining or monitoring its credit rating, but theparties may not have to disclose oral communicationsthat are merely operational or logistical in nature”

1 Release No. 34-61050; File No. S7-04-09; 74 Fed. Reg. 63832 (December 4, 2009), http://www.sec.gov/rules/final/2009/34-61050.pdf.

forward, such representations willbecome a part of the standard contractsentered into between NRSROs andAppointing Parties.

Coverage of the RuleThe Rule applies to NRSROs which havea “conflict of interest” as a result ofissuing or maintaining a credit rating for asecurity or money market instrument thatis backed by an asset pool or that isissued as part of an asset-backed ormortgage-backed securities transactionfor which the rating is paid by the issueror underwriter of the security or moneymarket instrument.

The Rule does not provide a territorial orjurisdictional limitation to disclosure.Recently, the SEC issued an order (the“Order”) temporarily exempting certainnon-U.S. transactions from compliancewith the Rule for a six month period (i.e.,until 2 December 2010). Specifically, theexemption is available for ratings ofstructured finance products (i) issued bynon-U.S. persons and (ii) where theNRSRO rating the transaction “has areasonable basis to conclude” that thestructured finance product will be offeredand sold upon issuance, and that anyarranger linked to the structured financeproduct will effect transactions of thestructured finance product after issuance,only in transactions that occur outsidethe U.S. The determination of “reasonablebasis” will depend on the facts andcircumstances of a given situation. TheSEC notes that, in order to have areasonable basis to make theseconclusions, the NRSRO should discusswith any Appointing Party linked to thestructured finance product (i.e., thesponsor, underwriter, and issuer) howthey intend to market and sell thestructured finance product and how theyintend to engage in any secondarymarket activities (i.e., re-sales) of the

structured finance product. The SEC alsostates that an NRSRO “may choose toobtain from the arranger” a representationupon which the NRSRO can reasonablyrely that sales of the structured financeproduct will meet this condition. Factorsthe SEC identify as relevant to theanalysis of whether such reliance wouldbe reasonable include the following:(1) ongoing or prior failures by thearranger to adhere to its representations;and (2) a pattern of conduct by thearranger where it fails to promptly correctbreaches of its representations.

For transactions not covered by theOrder, the Rule by its terms applies toratings for structured finance productsissued after 2 June 2010. However, aftermuch discussion in the industry, it hasbeen generally accepted that the actualimplementation date will depend on theinterpretation given to the Rule by therelevant NRSRO. Each of Moody’s, S&P,and Fitch have made statements settingout their interpretation of theimplementation date and, interestingly,the agencies have taken slightly differentviews. Fitch seemed to draw a bright-line– any engagement letters signed andreturned to Fitch on or after 2 June 2010will need to contain the relevantrepresentations by the Appointing Party.Moody’s and S&P seem to haveinterpreted the Rule’s implementation in asimilar way, but their approach is slightlydifferent to that of Fitch. Moody’s statedthat where the “rating process has beeninitiated” on or after 2 June 2010,compliance with the Rule will be required.Following Moody’s interpretation, if anengagement letter is dated before 2 June2010 but sufficient information is onlyprovided to Moody’s so that they begintheir rating analysis on or after 2 June2010, compliance with the Rule will stillbe required. Similar to Moody’s, S&P hasinterpreted the implementation date on

the basis that securities for which S&Phas sufficient information to begin theratings process before 2 June 2010, willnot be subject to the Rule. Additionally,securities for which S&P currently hasinsufficient information to begin the ratingprocess but for which S&P does receivesufficient information prior to June 2, S&Pwill inform the appropriate participants ifthe transaction will be posted to thepassword protected website.

Implications for AssetBacked Commercial PaperThe proposed regulations are particularlycomplicated for sponsors of AssetBacked Commercial Paper (“ABCP”)programmes, for which the ratings wereissued once at the start of the program,typically many years ago (and thereforewould not appear to trigger compliancewith the Rule). The SEC believeshowever that, despite the plain readingof the Rule, the basic provisions of theRule should nevertheless apply to ABCPprogrammes, and asked the industry topropose a compliance methodology.Moody’s recently stated that it will requireABCP programmes that received aninitial rating prior to 2 June 2010 toprovide Moody’s with a representationthat it has posted the following: allprogramme-level documentation in itsthen-current form, a copy of the mostrecent report on programme-ownedassets, and all offering documents intheir then-current form. This follows aformal proposal to the SEC made by theAmerican Securitization Forum (“ASF”),an organisation which providesinformation on issues related tosecuritisations and which represents theinterests of arrangers, underwriters,originators and issuers of structuredproducts. Under the ASF’s proposal, on2 July 2010 (i.e., one month after theSEC’s required implementation date)


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ABCP programmes would uploadhistorical information on the ABCPprogramme, including the conduitorganisational documents, theadministration agreement, the securityagreement, the management agreement,the investment guidelines, theprogramme-wide credit enhancementdocuments, the forms of liquidityagreement, and the most recent reportsof all of the assets. Additionally, theprogramme would disclose prospectiveinformation, including all of theinformation given to the NRSRO or anycontracts with third parties to provideinformation to the NRSRO. While thispropsal has not been approved by theSEC, ASF created this plan followingmeetings with the SEC to discussthe Rule.

Practical implications fortransactions involvingstructured finance productsWhile the proposed amendments to theRule apply to NRSROs, and not directlyto the Appointing Parties, if theAppointing Parties do not properlydisclose information provided to hiredNRSROs, they risk losing their currentcredit rating for relevant transactions andthey may be unable to obtain future creditratings from the NRSRO. Because manystructured finance transactions requirecredit ratings, such a result would havesignificant adverse effects on theAppointing Party. As such, the process ofposting information to the passwordprotected website is receiving extensiveattention among market participants.

Practically, ensuring that all informationgiven to hired NRSROs iscontemporaneously uploaded to thewebsite will be a complex task.Appointing Parties will have to beextremely vigilant in ensuring that anywritten documentation (and any relevantinformation provided orally) provided tothe NRSROs is also uploaded ateffectively the same time onto thewebsite. For market participantsconsidering requesting a rating for atransaction which would fall within thescope of the Rule, we stronglyrecommend developing a complianceprocess to ensure that the requirementsof the Rule are met. Clifford Chance arepleased to advise interested parties inthis area.

“Practically, ensuring thatall information given tohired NRSROs iscontemporaneouslyuploaded to the websitewill be a complex task”

ConclusionThe SEC proposed amendments to the Rule will significantly alter the relationshipbetween Appointing Parties of structured finance transactions and NRSROs. RequiringAppointing Parties and NRSROs to maintain websites with current information anddisclosures will be a challenging undertaking. Many of the details of this Rule are stillunclear, and those involved in structured financial markets should continue to monitorthe SEC’s comments and proposals for updates and clarifications.

5. How the German legislatorhopes to save the Germanfinancial system

On 18 May 2010, the German FederalFinancial Services Supervisory Authority(Bundesanstalt fürFinanzdienstleistungsaufsicht – “BaFin”)announced new temporary prohibitions oncertain naked short-sales and on 25 May2010 the Federal Ministry of Financeproposed an even further reachinggeneral ban on short-selling as part of afurther amendment to the SecuritiesTrading Act.

Since the onset of the financial marketscrisis, regulators and legislatorsthroughout Europe have developed anumber of initiatives to deal with itsconsequences and supposed underlyingcauses in order to protect the public (andthemselves) from the danger of anothercrisis in the future. This article pertains tocertain particularly relevant initiatives of theGerman legislator and/or regulator duringthe last year and their practicalimplications for the structured debt world.

Some of these legislative and regulatorymeasures are intended to implementEuropean Union law, for example, thechanges to the Capital RequirementsDirectives. Others transpose supranationaldecisions into German law, such as theG20 countries Financial Stability Board’s(“FSB”) rules on remuneration in thebanking sector which led to amendmentsto the BaFin’s Minimum Requirements forthe Risk Management of Banks(“MaRisk”). But some are also of a purelydomestic nature (most notably theFinancial Markets Stabilisation Fund andthe ban on naked short-selling announcedrecently). Some of these measures are oftemporary nature only (such as, again, theFinancial Markets Stabilisation Fund), whilesome are in fact permanent new rules.

All of them have in common that they areintended to help stabilise and strengthenthe financial markets. This article gives asummary of the various measures and thecurrent state of implementation.

SoFFin – effort and effectIn October 2008, at the height of thefinancial markets crisis and shortly afterthe Lehman Brothers’ insolvency,Germany sought to stabilise the financialsector by establishing the GermanFinancial Markets Stabilisation Fund(Sonderfonds Finanzmarktstabilisierung,the “SoFFin”). The SoFFin is administeredby a public law institution, the FinancialMarket Stabilisation Institution(Finanzmarktstabilisierungsanstalt, the“FMSA”) which is attached to Germany’scentral bank and supervised by theFederal Ministry of Finance. Its objectivesare to preserve, stabilise and restructurethe financial markets in Germany. Itsmarket-supporting measures (i) aretemporary and only available until 31December 2010; (ii) are available on avoluntary basis; (iii) aim to minimise thepotential burden on taxpayers by chargingfees for its usage equivalent to marketprices; and (iv) promote the adoption bybanks of compensation models which donot encourage excessive risk-taking.

The SoFFin was put in place to alleviate(i) the general lack of liquidity, by means ofstate guarantees for newly issued debtsecurities and certain other liabilities,(ii) the shortage of capital, by acquiringparticipations in financial sectorenterprises and (iii) the pressure towardsdepreciation, by assuming risk positions(e.g. liabilities and securities) and grantingreliable debt securities issued by theFederal Republic of Germany in return.

The SoFFin has so far providedguarantees of approximately EUR 144 bn

to support various banks and providedEUR 28 bn as capital increases in AarealBank AG, Commerzbank AG, Hypo RealEstate Holding AG and WestLB AG.Despite charging fees at market rates, theSoFFin recorded a loss of approximatelyEUR 4 bn in 2009, most of which wasapparently related to the support of HypoReal Estate.

On 23 July 2009, the German Act for theFurther Development of Financial MarketStabilisation (Gesetz zur Fortentwicklungder Finanzmarktstabilisierung) - came intoforce and added the “bad bank concept”and the “AidA concept” to the SoFFin’spotential range of support measures.

The aim of the bad bank concept was tostabilise the position of banks and otherfinancial institutions by allowing them totransfer any “toxic” assets which cameinto existence prior to 31 December 2008to special purpose vehicles (each an“SPV”) thereby removing these assetsfrom the relevant institution’s balancesheet. Such SPVs would issue bondsbacked by these assets to the relevantbank in consideration of the transfer of theassets and these bonds would then beguaranteed by the SoFFin. On the basisof such guarantees, such bonds wouldalso be eligible as collateral for thepurposes of the European Central Bank’sEurosystem liquidity scheme.

However, the bad bank concept was notused in practice. Write downs required atthe time of the transfer of the assets andthe potential suspension of dividendpayments required under the SoFFin rulesmeant that banks were reluctant to use it.

The recently published new policy on certain short-sales has not been the firstanti-financial markets crisis measure by Germany and, unfortunately, it will also not bethe last one.

New Horizons 30

“The SoFFin has so far provided guarantees ofapproximately EUR 144 bn to support various banksand provided EUR 28 bn as capital increases in AarealBank AG, Commerzbank AG, Hypo Real Estate HoldingAG and WestLB AG”


Further concerns related to the limitationto “toxic” (instead of illiquid) assets, whichhave been difficult to identify and whichwere not the main cause of the crisis, aswell as to the lack of tax provisionsdesigned to mitigate the impact onshareholders. Applications for thenecessary SoFFin guarantee could onlybe made up until 22 January 2010 andthe bad bank concept is therefore nolonger available.

The AidA concept addresses public lawbanks and allows for the transfer of “toxic”assets as well as of non-strategic business(“risk positions”). Banks (and their SPVs)may transfer risk positions taken prior to31 December 2008 to a “liquidationinstitution” (Abwicklungsanstalt). Theliquidation institutions may assume riskpositions through universal succession byseparation or spin-off or through thetransfer of assets. Alternatively, theeconomic risk of a position may beassumed by the liquidation institutionthrough guarantees, trust arrangements,swaps or sub-participation. The transfer ofa risk position will only be allowed if thetransferring entity or, in the case of an SPV,the relevant bank participates in the lossesof the liquidation institution in proportion toits participation. Applications to utilise aliquidation institution in accordance withthe AidA concept have been made byHypo Real Estate and WestLB AG.

The SoFFin may only grant newstabilisation measures until 31 December2010. However, this does not affect anymeasures already granted andoutstanding on such date and does notprevent further capital participations tosupport existing stabilisation measures.Eventually, the SoFFin will be unwoundand dissolved and any remaining fundswill be distributed between the Germangovernment and the state governments.

The good bank model,genuinely good?In addition to stabilisation measuresduring the crisis there was also a demandfor new statutory measures to helpprevent future crises by ensuring that keyinstitutions can be more easilyrestructured, reorganised and/or have keyparts of their businesses isolated andtransferred. In August 2009, the Germangovernment published two drafts(together, the “draft Bill”) for a new act onbank insolvency and pre-insolvency rules.The legislative process was, however, puton hold due to the general election inGermany in September 2009. On 31March 2010, the German Ministries ofFinance and Justice jointly announcedthat, among other measures described inmore detail below, they plan to developproceedings allowing for “voluntaryrestructuring” as well as for “organisedliquidation” of banks. A revised draft of thedraft Bill is therefore expected soon.

The old draft Bill sets out three types ofpre-insolvency proceedings for“systemically relevant” banks: (i) voluntaryrestructuring, (ii) reorganisationproceedings and (iii) transfer order to forcethe relevant bank to transfer the whole orparts of its business to another bank orSPV. “Systemically relevant” institutionsare institutions which, due to their size,the intensity of their interbank relationsand their close interdependence withforeign countries, could, if they were tofail, trigger significant negative effects atother credit institutions and lead toinstability within the financial system.

The draft Bill provides that a systemicallyrelevant institution may apply voluntarily tothe BaFin for restructuring proceedings if itno longer has sufficient own funds orliquidity. If the application is approved, arestructuring advisor will implement therestructuring in consultation with the BaFin.

If the restructuring is not successful, areorganisation plan may be put in place.The reorganisation plan would provide forthe liquidation of the bank and/or thepermanent limitations of creditors’ andshareholders’ rights. In addition, thereorganisation plan would includemeasures such as the conversion ofclaims against the bank into equity, capitalincreases or reductions, changes to thebank’s articles of association and thespin-off or hive-down of certain assetsand/or business areas to another entity.

Furthermore, the BaFin may order asystemically relevant institution to transferthe whole or part(s) of its key business toanother bank or a public law institution(Übergangsanordnung) if: (i) the existenceof the bank is endangered, in particular ifthe bank’s own funds or liquidity has fallenbelow 90 per cent of the required ratio orif there are reasons to believe that such asituation will occur; and (ii) this in turncould endanger the stability of thefinancial system. Should the transferringbank become insolvent, the transfer willbe protected from any claw-backprovisions under German insolvency laws.


31 New Horizons

“In addition to stabilisationmeasures during the crisisthere was also a demandfor new statutorymeasures to help preventfuture crises by ensuringthat key institutions canbe more easilyrestructured, reorganisedand/or have key parts oftheir businesses isolatedand transferred”


New Horizons 32

In addition, the draft Bill states: (i) thatnone of the above measures will entitle acounterparty of the relevant bank to earlytermination of contractual relationships;and (ii) that contractual clauses whichprovide for the contrary shall be invalid.However, it is doubtful whether suchprovisions would be given effect by non-German courts. In addition, the proposedlimitations on contractual terminabilitywould create serious doubt as to whethernetting arrangements with systemicallyrelevant institutions in Germany would stillbe enforceable in a crisis scenario. If not,the resulting need to cover the aggregate(rather than the net) exposure to suchbanks with regulatory capital would placeGerman banks at a significantcompetitive disadvantage.

It remains to be seen how the issuesmentioned above will be reflected in thenext draft of the Bill.

More ideas for fallen stars -further governmentinitiatives for failing banksOn 31 March 2010, the German Ministriesof Finance and Justice announced furtherproposals which, together with the draftBill, are designed to facilitate a quickerand more efficient reaction to turbulencein the financial markets.

In order to ensure that the financeindustry itself supports any bail-out andrestructuring of banks in any futurefinancial crisis, the German governmentintends to implement a stabilisation fund(Stabilitätsfonds) to be administered bythe FMSA. This fund is to be financed bymeans of a contribution by all Germanbanks, in proportion to the risk posed tothe financial system by the relevant bankby reference to the amount of its liabilities(i.e. “too big to fail”) or the degree of itsconnections in the financial markets (i.e.“too interconnected to fail”). However,

these proposed measures are the sourceof substantial debate (including at a globallevel within the G20).

Given that - in the German government’sview at least - the FMSA has had somesuccess, the government furtherconsiders that its mandate should bebroadened so that, apart from theadministration of the stabilisation fundSoFFin, the FMSA could also becomeresponsible for restructuring measures inthe banking sector.

Finally, the German Ministries of Financeand Justice have stated in theirannouncement that the executive boardsof credit institutions should take moreresponsibility in the case of breach of theirduties by extending the statutory period oflimitation regarding claims resulting fromsuch breaches from five to ten years. Thisis intended to ensure that claims can stillbe brought against executive members ofstock corporations if the composition ofthe executive boards has changed in themeantime or such claims became knownonly at a later date.

A draft law incorporating the above-mentioned measures is expected in thenear future.

Stronger supervision undera new statuteThe German Act for the Strengthening ofthe Financial Markets and InsuranceSupervision (Gesetz zur Stärkung derFinanzmarkt- und derVersicherungsaufsicht, the “StrengthenedSupervision Act”) came into force on 1August 2009 and primarily amended theGerman Banking Act (Kreditwesengesetz- “KWG”) and the German InsuranceSupervisory Act(Versicherungaufsichtsgesetz). The followingis a summary of the main amendments thataffect credit institutions and financialservices institutions (each an “institution”).

The power of the BaFin to impose higherindividual capital requirements on aninstitution or a group of institutions hasbeen extended, in particular: (i) to accountfor risks that are not currently subject toregulations; (ii) if the “risk-bearingcapacity” of the institution is no longerensured; (iii) to create an additional “equitycapital buffer” during an economicdownturn; and (iv) to account for specialbusiness circumstances. In addition, theBaFin can impose higher capitalrequirements as a pre-emptive measurerather than a measure of last resort inrespect of shortcomings of an institution’sinternal business organisation.

In addition, the BaFin is now authorised incertain circumstances to individuallyimpose higher liquidity standards in orderto safeguard an institution.

The BaFin now has the power to imposea ban on payments by an institution to itsintragroup creditors (“ring-fencing”) if itconcludes that the discharge of theinstitution’s obligations vis-à-vis itscreditors or the safety of the assetsentrusted to it are at risk or that effectivesupervision is not safeguarded. Thepurpose of such a ban would be toprevent a German institution from beingdeprived of liquidity by its (non-German)parent company or affiliates, a problemwhich for example arose during thecollapse of Lehman Brothers.

The distribution of profits toshareholders can also now beprohibited if there is a danger of theinstitution falling below (rather than anactual failure to meet) the supervisoryratios in respect of the institution’s ownfunds or liquidity. Moreover, the BaFin isauthorised to prohibit the repaymentand distribution of profits in the contextof hybrid capital instruments.

In general, the Strengthened SupervisionAct therefore allows for severe limitations

33 New Horizons


of shareholders’ rights based on a mereforecast of an institution’s ability to fulfilsupervisory requirements. It also stipulatesthat conflicting contractual rights ofholders of equity instruments are notenforceable. Furthermore, the BaFin isnow able to prohibit or restrict“accounting measures that serve tooutbalance an annual net loss or todisclose an annual net profit”. All of thesemeasures apply to superordinatecompanies (übergeordnete Unternehmen)of financial holding groups and of groupsof institutions. In certain circumstancesthese measures can be taken withoutprovision of a transitional period.

The Strengthened Supervision Actintroduces detailed reporting requirementsfor institutions which are intended toextend the BaFin’s information databaseto enable it to better identify riskconcentrations within groups ofinstitutions. The superordinate companyof a group of institutions is obliged todisclose to the BaFin certain intragrouptransactions that reach or exceed 5 percent of the amount of own funds requiredat group level. In addition, ad-hocreporting is required with respect to anytransaction that might endanger theadequacy of the superordinate company’sown funds. The Act also requiresinstitutions and groups of institutions toreport regularly on their “leverage ratio”which is intended to help detect additionalon- or off-balance sheet risk potentials.

The Strengthened Supervision Act alsointroduces certain qualification

requirements for members of thesupervisory boards of companies in thefinancial sector.

Other developmentsOther initiatives that are being brought inor that are under consideration include:

n the draft bill for the implementation ofCRD 2 including provisions regardingre-securitisation from the current CRD3-proposal whose adoption hasbeen postponed;

n the announcement of the Germangovernment on 23 February 2010 thatit will consider introducing a“Securitisation Act” to set out “uniformand transparent standards for asset-backed securities”;

n the draft bill for the implementation ofRegulation (EC) No 1060/2009 oncredit rating agencies, which providesfor an annual audit to be performed byauditors appointed by the BaFin; and

n the discussion draft of the FederalMinistry of Finance for an “Act toStrengthen Investor Protection andEnhance Functionality of theCapital Market” published on 3 May2010, providing for the followingkey measures:

• stricter investor protection standardsin the “grey capital market”;

• new compliance requirements forinvestment advisors and personsexerting influence ondistribution targets;

• prohibition of naked short sellingtransactions (and a mandatoryreporting system for coveredshort sales);

• disclosure requirements for cash-settled derivatives (aiming to preventan unnoticed “sneaking-up” onGerman listed companies); and

• minimum holding periods andenhanced liquidity requirements foropen-ended real estateinvestment funds.

These other initiatives, together with thedraft Pre-Insolvency Bill (not to mentionother supranational and Europeanlegislative or regulatory projects, such asfor example the clearing of over-the-counter derivatives via exchanges orother central counterparty systems),mean that the German financial sector,already traditionally one of the mosthighly regulated markets in the world, willcontinue to be subject to constantchange and increasingly stringentrequirements, and that Germanlegislative initiatives will remain of interestto the structured debt world for theforeseeable future.

In summary, it is fair to say that some ofthe German legislative or regulatorymeasures introduced to stabilise andrevitalise the financial markets have beenmore appropriate and more successfulthan others, and it looks as if the sameholds true with respect to the forthcominglegislative and regulatory projects. Thebiggest danger for the future of thefinancial markets in Germany as well as inEurope and globally is currently that theunderestimated aggregate of all thesemany good or well-intended new rulescompletely overburden the market playersand effectively encumber the desperatelyneeded recovery of the markets. As forthe industry, finger-crossing might not besufficient to avoid this undesired result.

“The biggest danger for the future of the financialmarkets in Germany as well as in Europe and globally iscurrently that the underestimated aggregate of all thesemany good or well-intended new rules completelyoverburden the market players and effectively encumberthe desperately needed recovery of the markets”

New Horizons 34


6. Significant risk transfer andsynthetic securitisation


This FSA letters affect both traditional,funded synthetic CLO transactions, aswell as funded or unfunded privatetransactions which provide credit riskmitigation under BIPRU 5.7.1

In order to qualify as a syntheticsecuritisation, a transaction needs to meetthe requirements of both Chapters 5 and9 of BIPRU. For the purposes of thisarticle, the key requirements in Chapter 9are that the transaction must have atranched capital structure, and that thetransaction must provide significant risktransfer. However, in contrast to a “cashsecuritisation”, the mechanism by whichthis risk transfer is achieved is by meansof a credit risk mitigant (such as a creditdefault swap or a guarantee) which mustalso comply with the requirements forobtaining regulatory capital relief pursuantto Chapter 5 of BIPRU.

While the issue of what constitutessignificant risk transfer initially arosefollowing the FSA letters, it has recentlybeen taken up by other Europeanregulators, some of whom have followeda similar approach to the FSA.

The original issueThe FSA’s concern originally arose inresponse to transactions in which theaggregate of the premium payable by theoriginator (as buyer of credit protection)was equal to, or exceeded, the maximum

loss which could be suffered by theseller of credit protection under thetransaction. The effect of this was that,unless the buyer defaulted in itspayments of premium, the seller wouldnever lose money over the life of thetransaction. This was often coupled witha rebate mechanism whereby if, at thematurity of the protection period, theaggregate of the premium paid over bythe buyer exceeded the losses sufferedon the reference portfolio, that excess(less a profit to be retained by the seller)would be returned to the buyer. This hadthe effect of ensuring that, except inrelation to the seller’s profit element, thebuyer would not end up paying out morethan the actual losses suffered by it onthe reference portfolio. The combinationof these features was that the buyer waseffectively still exposed to the maximumpotential losses on the portfolio. It wouldseem that the FSA’s concern with thistype of transaction was that it did notappear that the buyer had actuallytransferred any risk in the referenceportfolio to the seller. All that it had donewas transform the timing of those losses.Whereas, without the transaction it wouldsuffer the losses as and when theyoccurred, with the transaction in place,the buyer would be required to make pre-determined payments at pre-determinedtimes, regardless of when the lossesactually occurred.

This is not to say that such transactionsmay not still serve a useful purpose.While over time, the buyer does remainexposed to the losses on the referenceportfolio, the time shifting of its paymentto the seller does radically transform theimpact which losses will have on thebuyer, and its ability to cover thoselosses from its capital reserves withoutthreatening its financial stability. Byremoving the timing uncertainty, theoriginator can provision more efficientlyto meet those losses. The rationale forholding capital against risk weightedexposures is to guard against the timinguncertainty associated with whether ornot those exposures will default. Bytransforming that uncertainty into astream of known and limited payments,the originator need not hold capitalagainst the entire exposure. Rather, thepremium payments will simply be anentry in the buyer’s profit and lossaccount, and therefore result in areduction in tier 1 capital to the extentpayments are made.2 Nevertheless, itappears that the FSA had significantconcerns with this type of transaction,leading it to pay closer attention totransactions which, while not always asextreme as this example, do involvethe originator bearing a significant costof protection.

While this article is primarily focussing onthe regulatory capital position of the

One issue which has been attracting the market’s attention recently is what constitutes“significant risk transfer” for the purpose of treating a qualifying transaction as a syntheticsecuritisation under BIPRU Chapter 9. This attention is largely the result of two letterswhich the Financial Services Authority (“FSA”) sent to the British Bankers’ Association on24 July 2009 and 26 February 2010, in which it expressed an interpretation of therelevant provisions of BIPRU which is at odds with the way most market participantshad previously understood the scope of those rules, and which poses a number ofissues for originators seeking to reduce their regulatory capital requirements by utilisingsynthetic securitisation techniques.

New Horizons 36

1 The FSA letters also addressed number of other issues related to synthetic securitisations such as the effect of incentives to unwind transactions early and proposed futureamendments to the CRD. However, this article focuses on an analysis of the FSA’s position on significant risk transfer.

2 This does not address possible concerns about how the seller of protection might be reporting the transaction. However, this article is concerned primarily with the position of theoriginator, not the seller.

originator, it is interesting to note that,where the protection seller is also aregulated entity, it is possible to see howthis could give rise to a regulatoryasymmetry. It would usually be expectedthat, as a consequence of entering intothe transaction, the buyer would report areduction in its risk weighted exposuresas a result of the protection receivedfrom the synthetic securitisation, whilethe seller would take those risk weightedexposures onto its balance sheet, andhold capital against them accordingly.However, given that the seller cannotsuffer a net loss (unless the originatordefaults in its payments of premium), theseller could argue that its only exposureis to the buyer which, as exposures tocredit institutions attract only a 20% riskweighting, would generate a lowercapital requirement than an exposure tothe reference portfolio itself. The result isthat, when the positions of the buyerand seller are combined (both beingregulated entities), the total risk inrelation to the reference portfolioremains unchanged. However, theamount of capital now held against thatrisk has been reduced significantly, withthe both the buyer and the seller holdingcapital against exposures to each otherand no one holding capital against thereference portfolio.

The FSA’s responseWhile the FSA’s concerns may havebegun with transactions where theaggregate premium payable would matchthe maximum potential losses, the impactof its response is being felt much morebroadly. The FSA has chosen to focus onthe requirement in BIPRU 9.3.2G that “thetransfer of credit risk to third partiesshould only be considered significant if theproportion of risk transferred is broadlycommensurate with, or exceeds, theproportion by which the risk weightedexposure amounts are reduced”. It then

adopts a “substance over form approach”to the determination of whether thetransaction does in fact result in thetransfer of credit risk to the seller ofcredit protection.

It would seem that the FSA has taken thisapproach at least partly out of a desire topresent its response as merely reinforcingwhat has always been the case – that is,that in order to obtain regulatory capitalrelief under a synthetic securitisation, thetransaction must provide significant risktransfer. From its perspective, all it hasdone in its letters of 24 July 2009 and 26February 2010 is provide further colour onwhat constitutes significant risk transfer inthis context.

In its letter of 26 February 2010, the FSAidentified three particular features of atransaction which may result in itdetermining that the amount of risktransferred is less than would otherwiseappear to be the case:

n first, where the amount of premiumpayable is “guaranteed”, or fixed, suchthat it does not reduce as losses areincurred on the portfolio. This couldtake the form of either an upfrontpremium or a premium which iscalculated at a fixed percentage of theinitial notional amount of the

transaction, regardless of whether ornot losses have occurred, and is to becontrasted with a variable premiumwhich is a function of the residualperforming balance of the tranche;

n secondly, a premium which issignificantly greater than the creditspread income on the assets in theportfolio or which, in aggregate, issimilar to the size of the protectedtranche itself; and

n thirdly, where the originatoreffectively retains exposure to theexpected loss through highertransaction costs which are payableto the seller, whether by way ofpremium or otherwise.

The FSA goes on to state that “[w]here atransaction has no explicit tranching, butthe terms (e.g. guaranteed premium)economically result in there being animplicit retained position or economictranching, the transaction should betreated as a securitisation under BIPRU9.” It is not clear exactly what the FSAmeans by this statement. Oneinterpretation is that this is intended torefer to any transaction which is not itselftranched, even if that transaction onlyreferences a single tranche of a broadercapital structure. However, suchtransactions should already be consideredtranched for the purposes of Chapter 9 ofBIPRU. It is therefore likely that thisstatement is intended to apply tountranched transactions which cover theentire capital structure of a referenceportfolio. As such transactions would notnormally constitute securitisations, theywould not be subject to the requirementsfor significant risk transfer under Chapter9 of BIPRU. Rather, they would only berequired to comply with Chapter 5 ofBIPRU, which has no such requirement. Ifit is the FSA’s intention to treat suchtransactions as securitisations, then the


37 New Horizons

“The transfer of credit riskto third parties should onlybe considered significant ifthe proportion of risktransferred is broadlycommensurate with, orexceeds, the proportion bywhich the risk weightedexposure amounts arereduced”


New Horizons 38

effect of this would be that a transactioncovering the entire capital structure of aportfolio, but which had, for example, aguaranteed premium, would no longer beeligible to provide regulatory capital reliefas a result of the requirement in BIPRU9.1.3 to calculate the risk weightedexposures in relation to a securitisationposition in accordance with Chapter 9 ofBIPRU coupled with the limitation inBIPRU 9.3.1 which only permits the useof reduced risk weighted exposureswhere the transaction achieves significantrisk transfer.

Despite the FSA stating that it isconcerned about whether or not therehas been significant risk transfer, this is, inpractice, a blunt instrument, and notnecessarily the most appropriate way ofapproaching these transactions.Undoubtedly, risk has been transferred. Itis now the seller who is exposed to thelosses on the portfolio, whenever theyhappen to occur. The real issue is notwhether or not there has been significantrisk transfer (which is a binarydetermination), but rather whether theway in which that risk has beentransferred has occurred means that thereis implicitly an additional tranche ofretained risk or some other retainedposition which must be deducted fromcapital. In the case of transactions suchas those described above where thepremium matches the maximum losseson the transaction, the size of that implicitretained position would indeed be toolarge to leave room for significant risktransfer in relation to the transaction.

However, in many other cases, theposition may not be so extreme, such thatit would be an overreaction to disallow therecognition of the entire transaction for thepurposes of BIPRU 9. This would also tiein rather neatly with the proposedamendments to the Capital RequirementsDirective which will introduce more explicitthresholds for determining exactly howmuch risk must be transferred in order fora transaction to qualify as significant risktransfer. Anecdotal evidence suggeststhat this is, in fact, the way in which theFSA is approaching such transactions.Rather than disqualify a transactionoutright, it is requiring adjustments to bemade to the amount of regulatory capitalrelief generated by the transaction to takeinto account the effect of a significantupfront premium, etc.

Concerns with the FSA’spositionThe FSA’s approach does highlight thefine line that exists between the cost ofcredit protection and credit enhancement.That is, if the cost of purchasing creditprotection is a function of the expectedlosses on the portfolio, then that cost canbe reduced by credit enhancements (suchas a synthetic excess spread or a firstloss tranche) which reduce thoseexpected losses. An originator can,therefore, either pay a higher premium, orsupport the structure with other types ofenhancements. Where the transactionincorporates a rebate mechanic along thelines discussed above, the economiceffect for both the originator and the seller

will be substantially the same, whicheverapproach is followed, although this will notnecessarily be the case in a transactionwithout a rebate mechanism, where theseller is likely to receive a greater return byway of an increased premium than itwould from other forms of creditenhancement. This realisationdemonstrates that it is unlikely to be in theoriginator’s interest to agree to a higherpremium rather than employ other formsof credit enhancement, as the ultimatecost to the originator will end up beinggreater. This suggests that if a highpremium is being paid, it is simplybecause that is what the market demandsin order to provide credit protection on therelevant reference portfolio. In light of this,it is perhaps surprising, albeitunderstandable, given the nature of thetransactions which initially gave rise to itsconcerns, that the FSA has chosen tofocus on whether there has beensignificant risk transfer rather than onwhether the way in which the premium(and any potential rebates) have beenstructured is such as to constitute a typeof credit enhancement.

Nevertheless, however the FSA choosesto classify its approach, it does cause anumber of concerns, which potentiallyundermine an originator’s ability to enterinto a synthetic securitisation transactionat all.

Most obviously, by treating a premium asakin to a retained first loss tranche wherethat premium is either guaranteed in all (ormost) circumstances or is significantlygreater than the spread income on theassets in the reference portfolio, it mayactually become impossible for anoriginator to obtain significant risk transferin respect of a reference obligation orportfolio. Consider, for example, areference portfolio comprising commercialreal estate loans that were originated withrelatively low spreads prior to the onset of

“Anecdotal evidence suggests that rather than disqualifya transaction outright, the FSA is requiring adjustmentsto be made to the amount of regulatory capital reliefgenerated by the transaction to take into account theeffect of a significant upfront premium”

39 New Horizons


the financial crisis. Given the decline incommercial real estate values since then,it is likely that the cost of purchasingcredit protection in respect of such areference portfolio could now besignificantly greater than the spreadgenerated on the portfolio. However, theFSA’s approach would appear to suggestthat, to the extent that the originator isrequired to pay this higher cost topurchase credit protection, it will not bepermitted fully to recognise significant risktransfer in respect of the referenceportfolio. Perversely, as the assetdeteriorates, and it becomes moreexpensive to purchase credit protection, itwill become harder for the originator tosatisfy the FSA that the creditprotection does in fact result in significantrisk transfer.

The focus on a “guaranteed” premium(that is, a premium which remainsconstant throughout the life of atransaction, despite losses being incurredon the portfolio) can, in somecircumstances, also result in the originatoractually being required to pay a higherpremium than would otherwise be thecase. This is because the originator andthe seller may have a different view of therate and frequency at which losses willoccur on the portfolio. Where thepremium is expressed as a percentage ofthe performing balance of the portfolio,the seller may be inclined to assumelosses will occur rapidly, and therefore willdemand a higher premium in order toensure it generates its desired overallreturn over the life of the transaction. Onthe other hand, the originator, which isultimately in the best position to gauge thelikely rate at which losses will occur on theportfolio, may expect that those losses willoccur at a much slower rate. On thisbasis, it may be in both parties’ intereststo structure the premium as a guaranteed

coupon, whereby the seller has certaintythat it will receive its desired overall return,but the buyer is protected from the riskthat it will end up paying much more forthe protection if it is correct and thelosses accrue more slowly than the selleranticipates. The ultimate irony of this isthat the FSA’s dislike of a guaranteedcoupon approach may actually result inthe originator having to pay a higherpremium which, of course, puts it at riskof breaching the FSA’s other concern,namely a premium that is significantlygreater than the spread generated by thereference portfolio itself. Thus, theoriginator finds itself unable to achieve acomplete risk transfer in respect of thereference portfolio.

Where to from here?There are two clear messages whichcome out of the FSA’s position on thesetransactions. First, that it is concernedabout market participants takingadvantage of potential gaps in theregulatory framework to exploit perceivedarbitrage opportunities. Second, that toaddress this concern, the FSA will betaking a much more interventionist andhands-on role in determining whether toallow originators to recognise suchtransactions as synthetic securitisationsfor regulatory capital purposes.

The wide-ranging impact of the FSA’sresponse appears to be deliberate, while

also being sufficiently broad as to providescope for individual transactions to beapproved where the FSA is satisfied thatthey are consistent with its interpretationof the spirit of BIPRU. It is, therefore,difficult to state categorically, for example,at what point a premium is too high.Rather, in place of such black and whiterules, originators will need to engage in adialogue with the FSA, in which they willneed to be able to demonstrate how theyhave determined the pricing and timing ofpayments which will apply to a particulartransaction and why that structure isappropriate in light of the prevailingmarket conditions.

The FSA has been quite explicit that itexpects firms to approach it at an earlystage to discuss proposed transactions. Ifa firm does not do so, the FSA will expectthe firm not to claim any regulatory capitalreduction from those transactions in anymarket disclosure without also including awarning about the risk of reassessment ofthe regulatory capital relief provided by thetransaction if that risk “is material in lightof [the FSA’s] stated policy”. Unfortunately,as is apparent from the discussion above,this risk would seem to be material inrespect of any transaction where thestructure is any more complicated than asimple periodic premium, which is lowerthan the spread on the reference portfolioand which is calculated against theperforming balance of the portfolio.

“By treating a premium as akin to a retained first losstranche where that premium is either guaranteed in all(or most) circumstances or is significantly greater thanthe spread income on the assets in the referenceportfolio, it may actually become impossible for anoriginator to obtain significant risk transfer in respect ofa reference obligation or portfolio”

New Horizons 40


Beyond the UKWhile we are not aware of any otherregulators publishing a formal publicposition on these issues, anecdotalevidence suggests that the FSA’s positionhas resulted in a number of otherEuropean regulators also revising theirtreatment of these transactions. Someappear to be following the FSA’s stricterapproach, while others have not, at leastto date. It will be interesting to see howthis issue develops, particularly in thecontext of the proposed changes to theCapital Requirements Directive. The FSAhas, so far, stated that it does not expectthese amendments will change theirpolicy objectives on significant risktransfer. Whether other regulators will usethese amendments as a catalyst for arevised approach remains to be seen.

“The FSA has been quite explicit that it expects firmsto approach it at an early stage to discuss proposedtransactions”

7. ECB liquidity transactions – arefresher and an outlook onchanges to come


The ECB’s schemeThe ECB has provided critical liquidity tothe market over the last few years. Acornerstone of its liquidity operations hasbeen its rules regarding the types ofassets it will accept as collateral forliquidity purposes. In this article, we lookat the rules as they have beenimplemented over the last few years anddiscuss the further changes which may beintroduced by the ECB to try to wean themarket off its liquidity operations and toencourage a return to market financing.

Eligible assets – a refresher

The ECB accepts two types of assets ascollateral for its liquidity schemes –marketable assets and non-marketable assets.

Marketable assets generally include:

n corporate bonds with an issuer orguarantor rated “A” or above;

n ABS rated “AAA”; and

n regulated covered bonds rated “A”or above.

Non-marketable assets are essentiallycredit claims (for example, loans) andnon-marketable retail mortgage-backeddebt instruments.

What isn’t eligible?

A number of factors may render particularsecurities ineligible. The main ones being:

n an issuer established outside the EEAand any of the other non-EEA G10countries (which means that securitiesissued by Cayman Islands or JerseySPVs are ineligible);

n bonds and covered bonds not havinga rating from one recognised rating

agency or, in the case of ABS, nothaving ratings from two recognisedrating agencies;

n the currency not being euro, or (until theend of 2010) sterling, US dollars or yen;

n the securities not being the mostsenior tranche;

n for ABS issued after March 2009, theunderlying assets comprising assetbacked securities;

n for ABS, the acquisition by the issuerof the underlying collateral for the ABSnot being a “true sale” governed bythe laws of an EU member state; and

n securities not being admitted totrading on a regulated market (orcertain non regulated markets asspecified by the ECB).

Close links – further tightening?

Counterparties wishing to use the liquidityscheme cannot have “close links” with theissuers of the securities they want to useas collateral. The primary prohibition is onsubmitting collateral which a counterpartyhas issued or guaranteed itself. There arealso other rules prohibiting other types of“close links”, such as the rule that if acounterparty submitting collateral providesany foreign exchange hedging to thecollateral, such collateral will not beeligible. To date, counterparties providinginterest rate hedging, or liquidity supportof up to 20% of the relevant transaction,have not fallen foul of the “close links”rule. In addition, a counterparty servicingassets has not been regarded as having a“close link” with the securities beingsubmitted for collateral purposes. Whilethere has been no official announcementin relation to any tightening of these rules,

there is speculation that the close linksrules may be further tightened in future.

To guard against a transaction ceasing tobe eligible for ECB liquidity purposes,consideration should be given to theinclusion in the transaction documentationof provisions allowing for a change ofinterest rate counterparty or liquidityprovider should that become necessary tocomply with any new “close links” rules.

True sale

For ABS to be eligible, the transfer of theunderlying assets to the issuer must be a“true sale”. This requirement is wellknown and national central banksroutinely request legal opinions from thenational central bank in the jurisdictionunder the laws of which the true sale is tobe achieved in order to confirm the truesale analysis. However, there have beensome extensions of the true salerequirement in particular deals whichhave been challenging for marketparticipants to satisfy.

This article looks at the rules governing collateral eligibility for the European CentralBank’s (“ECB”) liquidity scheme, which has been a lifeline to the market over the last fewyears. We discuss ECB rule changes and offer our observations as to where futurechanges may be made.

As the ECB’s rules change from time to time, it is important to ensure that there is enoughflexibility in deal documentation to allow for continued eligibility following a rule change.

New Horizons 42

“Consideration should begiven to the inclusion inthe transactiondocumentation ofprovisions allowing for achange of interest ratecounterparty or liquidityprovider should thatbecome necessary tocomply with any new“close links” rules”

Traceability of “true sale” toorigination and underlying assets:Historically, for true sale purposes, thenational central banks have (in line withthe text of the rules) never looked furtherback than the sale of the assets from theoriginator to the issuer of the securities.However, in recent transactions, thisapproach has been changing. For CDOsof ABS issued before March 2009,requests have been made for comfort thatnot only was the sale to the issuer of theunderlying ABS a true sale but also thatthe underlying ABS themselves were truesale transactions (a very difficultrequirement to satisfy unless thecounterparty requesting eligibility hadarranged the underlying ABS transactionsand could provide the true sale legalopinions delivered in relation to them).There was nothing in the rules whichsuggested that such an interpretationmight be made and an extendedapplication of the rule without warningwas not a welcome surprise. In addition,we are aware of CLO transactions wheretrue sale comfort has been required, notonly in relation to the sale by the originatorof a portfolio of loans to the issuer of thesecurities, but also in relation to theoriginator’s own acquisition of individualloans from the market. Again, it came asa surprise to the market participants inthose deals when the national centralbank extended the true sale requirementbeyond the sale of the underlyingcollateral by the originator to the issuer ofthe securities.

Originator trusts: The legal status oforiginator trusts in English law equates tothat of a “true sale” and structures usingEnglish law trusts have been accepted bynational central banks on manyoccasions. That said, there has been oneinstance which we are aware of where anAustrian originator trust structure wasrejected as being ineligible by the relevantnational central bank. Although we do not

anticipate any issues with tried and testedoriginator trust models (Austrian law isdifferent to English law) there is apossibility that national central banks mayanalyse the legal aspects of trusts andhow readily they equate to a “true sale” inmore depth going forward.

National central bank arbitrage

The central bank of the country where thesecurities being submitted are listed getsthe job of determining whether or not therelevant securities will be eligible forcollateral purposes.

Market participants have sometimesnoticed apparently different approachesbeing taken by the various nationalcentral banks over the interpretation ofeligibility criteria and turn-around timesfor applications. As a result,counterparties have occasionally tried toarbitrage these differences in order toachieve a particularly fast turn-around orthe acceptance of a particular type ofasset. The differences in approach werebroadly attributed to the fact that thenational central banks are generally veryseparate from each other and did not (ordid not appear to) have a particularlyjoined-up approach.

Recently, the degree of communicationbetween national central banks hasgreatly increased and as a consequenceof this their interpretation of the eligibilitycriteria has become more uniform.Accordingly, it would appear that theopportunities market participants mayhave had for central bank arbitrage havelargely disappeared.

In terms of organisation, the nationalcentral banks have started to allocatecertain tasks to one of their number toallow for greater consistency in applicationacross member states. For example, theFrench national central bank centrallydecides on the theoretical value of

securities the value of which cannot bedetermined in the market and where atheoretical valuation needs to be made.

Asset valuations

The absence of any real market for manyABS means that theoretical values haveto be assigned to such securities in orderfor the ECB to be able to calculate howmuch it can lend against those securities.In some instances, the values attributedby the ECB to ABS submitted forcollateral purposes have beensignificantly less than par. Counterpartiesfaced with low valuations havesometimes been successful in obtaining ahigher valuation, particularly where theissuer of the receivables has agreed toprovide enhanced disclosure on theunderlying assets.

Among other things, to assist withvaluation of ABS submitted as collateral, itis now clear that the ECB will publish newrequirements stipulating minimum ongoingdisclosure standards regarding underlyingassets that will need to be adhered to. Apublic consultation on the establishmentof loan-by-loan information requirementsfor ABS in the Eurosystem collateralframework closed on 26 February 2010.On 22 April 2010, the ECB announcedthat the study phase for its loan level datainitiative can be considered complete andthat the Eurosystem will now proceed withits preparatory work for such loan levelinformation requirements. This preparatorywork is expected to last approximately 6months and it is currently envisaged thatmarket participants will have a 12-monthadaptation period before having to submitloan level data.

The current ECB plans set forth that loanlevel data should not only be available tothe Eurosystem but also to the widermarket, thereby helping to restore“confidence in the securitisation markets”.It is intended that the required disclosure


43 New Horizons


New Horizons 44

should be an ongoing one (over the full lifetime of the relevant ABS) and thatstandardised asset-specific templatesshould be used. So far a draft loan leveltemplate for RMBS has been prepared.

The forthcoming ECB requirements on loanlevel data disclosure will inevitably placefurther administrative burdens on thosehaving to provide such information, both interms of updating IT systems and datacollection. Such standardised loan levelreporting can reasonably be implementedonly with respect to newly originatedassets where the originators have had achance to reflect the new Eurosystemrequirements in the origination process. Foralready existing assets and/or transactions,the information requested in the future maynot be available or may only be availableembedded in IT systems or reportingformats which are incompatible with thefuture ECB reporting templates. Therefore,a sufficiently long grandfathering period (orat least rules for some discretion in thisregard) will be essential.

Grandfathering

The grandfathering of changes to theECB’s eligibility criteria is not guaranteed.In instances where grandfathering is notpermitted, transactions which satisfied thecriteria at the time they were put into thescheme may no longer do so and wouldneed to be withdrawn if they do notcomply with the new rules.

If changes are not grandfathered, sufficientprior notice may be given so that marketparticipants are not taken by surprise. For

example, additional haircuts to ABStransactions and changes to the closelinks rules came into force on 1 February2009 with no grandfathering, althoughprior notice had been given to the marketthat these changes would be made.

An example of when changes werepartially grandfathered was in March 2009when ABS of ABS and CDOs of ABSbecame ineligible. However, the ECBgrandfathered the use of these types ofassets until 1 March 2010 provided theywere issued prior to 1 March 2009. As of1 March 2010, all ABS of ABS, or CDOsof ABS, have ceased to be eligible forcollateral purposes.

Two Ratings

One of the recent changes to the ECBrules which has had a significant impacthas been the introduction of therequirement that ABS should have tworatings to be eligible. This rule changewas publicised in November 2009 and,for ABS issued on or after 1 March 2010,such ABS will need to have two “AAA”ratings at issuance (each of which maydrop to “A” over the life of such ABS andstill remain eligible).

For ABS issued before 1 March 2009, it issufficient if one rating which remains “A”was obtained at issuance. However, from 1March 2011, ABS issued prior to 1 March2009 will not be eligible unless such ABShas obtained an additional “A” rating.

For ABS issued between 1 March 2009and 1 March 2010, such ABS will only beeligible if assigned a “AAA” rating atissuance (which can drop to “A” over thelife of such ABS). In addition, from 1March 2011, for ABS issued between 1March 2009 and 1 March 2010, anadditional rating of at least “A” will berequired for such ABS to remain eligible.

It is expected that many transactions willneed to be restructured prior to 1 March

2011 to ensure the continued eligibility ofsuch transactions for the ECB’sliquidity scheme.

Secured structures using non-ABScriteria

As there are different eligibility criteria forABS on the one hand, and corporatebonds and covered bonds on the other,there may be scope for structuring assetsinto one category if they do not fit intoanother. For instance, ABS securitiesrequire an “AAA” rating to be eligible, butthis is not of course always possible. Forsuch transactions, one entity (with an “A”rating itself or issuing with the benefit of aguarantee from an entity with an “A” rating)could issue bonds guaranteed by an SPV.The guarantee from the SPV could besecured on the underlying assets, in asimilar way to what happens in manycovered bond transactions (but withoutthe issuer actually being required (or able)to satisfy the requirement to issue aregulated covered bond). With this type ofstructure, assets not capable of backingan “AAA” rated ABS can be used tosupport or enhance an obligation issuedby an entity (or guaranteed by an entity)with an “A” rating, without the structurefalling within the ABS rules and, therefore,without the need to get an “AAA” ratingand provide a true sale opinion.

The future

The ECB’s open market operations werenever intended to be a permanent form offinancing for credit institutions. With thefinancial recovery that appears to beunder way, we expect a tightening of therules on what will constitute eligiblecollateral going forward. Credit institutionswhich currently rely heavily on the ECB fortheir funding requirements will need totake care to ensure that they canstructure assets that will be compliantwith future rule changes or be in aposition to restructure existing deals tomake them compliant.

“With the financialrecovery that appears tobe under way, we expecta tightening of the rules onwhat will constitute eligiblecollateral going forward”

8. The Financial ServicesCompensation Scheme and TheBanking Act 2009 – dealing withthe set-off risk


A recap of a few Englishlaw set off issues We do not purport to set out the Englishlaw set-off analysis in full in this article. Wewould. however, like to summarise a fewkey points in the analysis of the currentaccount set off risks under English law.

First, where the set-off right is availablefor a borrower (e.g. where such set-offright has not been excluded, or ifexcluded, is considered unenforceable),prior to the bankruptcy of the borrowerand/or the insolvency, liquidation oradministration of the originator, rights onthe part of the borrower to set-off anyamounts owing by it to the originatorunder the relevant assets may arise.Secondly, following liquidation/administration of the originator orbankruptcy of the borrower, the insolvencyset-off regime has no application to therelationship between the borrower andthe securitisation vehicle (as assignee ofthe assets from the originator) and thisrelationship will be governed by the pre-insolvency set-off rules. Thirdly, following aliquidation/ administration of the originator,the insolvency set-off regime will notextinguish any legal or equitable rights ofset-off between the borrower and theoriginator which accrued due prior tonotice of assignment being given to theborrower and these set-off rights wouldremain available to the borrower against

the securitisation vehicle as assignee ofthe assets.

We are aware that some rating agenciesare of the view that there is a significantrisk that a claim in respect of monies in acurrent account does not need to be dueand payable in order to be “accrued due”for insolvency set-off; rather it is sufficientthat the claim is in existence. Our opinionis that, in this situation, in respect of bankaccounts of a borrower with theoriginator, only cross-claims comprisingdeposits for which the time for paymenthas fallen due and for which demand hasbeen received by the originator prior tothe giving of notice, are capable of beingset off by the borrower against thesecuritisation vehicle in respect of theassets. In particular we consider that thecase of Joachimson v Swiss BankCorporation ([1921] 3 KB 110) issufficiently analogous and persuasive inits analysis of the current accountrelationship, to provide a high level ofsupport for our opinion.

For the purposes of this article, we willnot go into further detail of the legalarguments around applicability ofcurrent account set-off and we willproceed from the starting point that therating agencies consider there is a riskof current account set-off that needs tobe addressed.

Does the FSCS mitigate set-off risk in the context ofbank originator securitisationtransactions? The FSCS was established on1 December 2001 under the FinancialServices and Markets Act 2000 as acompensation fund of last resort forcustomers of authorised financial servicesfirms. If the originator is unable to pay, oris likely to be unable to pay claims madeby borrowers with respect to deposits1

they have on deposit with the originator(the “Depositor”), a maximumcompensation of £50,000 is available tothem under the FSCS2.

The FSCS is required to compensate anyDepositor in respect of a protecteddeposit (which, for example, wouldinclude amounts standing to the credit ofa current account), provided that theDepositor, in so far as it is able andrequired to do so, assigns the whole ofits rights to the FSCS. As a consequenceof such assignment of rights, theDepositor would give up any right of set-off. For deposits of £50,000 or less, thismechanism allows the FSCS to be animportant mitigant against the set-off risk.

Some consideration of set-off still exists,however, because payments under theFSCS before 31 December 20103 arerequired to reflect the overall net claim

Set-off, in its various guises, can pose a significant structural risk in the context ofsecuritisation transactions. In particular, a borrower can discharge debt owedultimately to an issuer by setting-off any amounts owed to it by the originator. Insecuritisation transactions, where the predictability and certainty of cash-flows are key,identifying and countering this set-off risk is vital. This article considers the role playedby the Financial Services Compensation Scheme (“FSCS”) in mitigating such risk ofset-off where the originator is a deposit taking UK bank, including the changes whichwill be effective from 31 December 2010. In the second half of this article, we discussthe Banking Act 2009 (the “Banking Act”) and the extent to which it complements theFSCS in further mitigating the set-off risk for bank originators.

New Horizons 46

1 An eligible depositor’s £50,000 limit relates to the combined amount in accounts under all the ‘umbrella’ of a single banking licence.2 The FSA Compensation Sourcebook (“COMP”) sets out the rules for the FSCS. For the FSCS to apply, there must be “eligible claimant” (COMP 4.2) with a “protected claim”(COMP 5.2) against a “relevant person” (COMP 6.2.1 R) who is in “default” (COMP 6.2.3R). All individuals are eligible compensation, but not all companies and partnerships.

against an originator (i.e. taking intoaccount any rights of set-off that anoriginator would be able to exercise againstthe Depositor’s claim). As a result, FSCSpayments before and after 31 December2010 would be calculated as follows:

n Pre-31 December 2010 scenarioThere will be deducted from anyDepositor’s compensation claim anysums owed by it to the originator withrespect to non-securitised debt. Asthe Depositor could be entitled touncompensated deposits equal to theamount of its non-securitised debt,they may not choose the FSCS route,choosing instead to set-off thewhole amount.

n Post-31 December 2010 scenarioPayments made to any Depositorpursuant to any compensation claimwill be made on a gross basis andfree from set-off. This will provideDepositors with an additionalincentive to use the FSCS, and to notexercise their rights of set-off againstthe originator.

Liquidity in interim period

The FSCS is currently required to makeany compensation payouts as soon aspossible and in any case within threemonths of the satisfaction of thequalification conditions. In PolicyStatement 09/11, the FSA announcedthat from 31 December 2010,requirements will be introduced wherebypayments to Depositors will be madewithin seven days of determination of thedefault of the financial institution. There isa risk that during this short period, aDepositor may suspend makingpayments that fall due in respect of thesecuritised assets during this period. Ifnotice of assignment has not yet beengiven then the Depositor will have existingrights of independent set-off. Although

independent set-off is only a proceduraldefence and cannot be raised unless aclaim is brought by the originator (orissuer), there is very little an originator cando if the Depositor does not hand over themoney in those seven days. It is not verylikely, for instance, that an originator orissuer would accelerate the loan (a self-help remedy not susceptible to proceduraldefences). Consequently, the timing anddelivery of notice of assignment becomesan important factor in reducing the risk ofset-off as opposed to the statutory regime.

FSCS and deposits greaterthan £50,000

It is arguable that the FSCS might notprove to be an effective mitigant of theset-off risk in respect of deposits whichare greater than £50,000. This isbecause, to the extent deposits exceedthe compensation limit, a Depositor maytry to “recover” the full amount of itsdeposit by exercising its right of set-off.However, it is our view that even in thesecases, a Depositor is likely to choose toelect the FSCS route due to its inherentadvantage – it reinstates their short termaccessible assets (the money in thecurrent account) instead of getting relieffrom the long term liability of the loan (orindeed from a lengthy litigation process) –and only seeks to exercise set-off inrespect of the excess over £50,000.

Do the Banking Act and thepowers of the authoritiesunder the Banking Act offeradditional comfort/mitigants?In light of the analysis above, it is ourview that the FSCS will, certainly from thestart of 2011, act as a full mitigant to anypotential set-off risk in respect of depositsup to a balance of £50,000. In thissection, we consider whether theBanking Act has any further mitigating

effect on set-off risk, in particular fordeposits of over £50,000.

Section 4 of the Banking Act sets outcertain special resolution objectives,which include the following:

n protecting and enhancing the stabilityof the financial system of the UnitedKingdom (including, in particular, thecontinuity of banking services);

n protecting and enhancing publicconfidence in the stability of thebanking system of the UnitedKingdom; and

n protecting depositors.

Ensuring that depositors have readyaccess to their investments (and therebymitigating the risk of a run on the banks)is likely to be a major consideration forthe authorities when they consider eachof the objectives above. The code ofpractice published under sections 5 and6 of the Banking Act (the “Code ofPractice”) specifically notes that continuityof banking services is relevant for theprotection of depositors and that oneaspect of public confidence in the stabilityof the banking system is the expectationthat deposits will be repaid in accordancewith their terms. The Code of Practicefurther notes that the protection ofdepositors can be achieved, for example,by facilitating fast payout to eligibledepositors under the FSCS, arranging abulk transfer of accounts through thebank insolvency procedure or facilitatingcontinuity of banking services.

It would be difficult to argue that cancellingthe accounts of the Depositors (on thebasis that their rights under thoseaccounts could be set-off against otherdebts owed to a originator) is conducive tothe attainment of any of the aboveobjectives – this could be contrary to thegeneral public’s legitimate expectation and


47 New Horizons

3 See FSA Policy Statement 09/11 published on 24 July 2009. From 31 December 2010, compensation payments will be made on a gross basis.


New Horizons 48

is likely to be perceived as unfair. This isbecause the Depositor may, for example,have lost an instant access deposit inreturn for being in the less valuableposition of having less long-term debt topay – in other words, causing a forcedrefinancing of long-term debt (for example,a mortgage) in what is likely to be a difficultmarket with a higher cost for credit.Moreover, its application would depend onwhether a depositor had chosen tomaintain other banking relationships withthe originator, thereby differentiatingbetween customers and treating themdifferently, and, importantly, it may delaythe return of deposits (since it will takesome time to establish the net position).

The swift transfer of deposits to anotherinstitution is likely to offer depositors thegreatest reassurance, and has the addedbenefit that they cannot then be subjectto set-off. We note that the deposits ofBradford & Bingley plc were promptlytransferred to Abbey National plc and thedeposits of Dunfermline Building Societywere promptly transferred to NationwideBuilding Society when those institutionsentered into the special resolution regime(and its antecedent regime under theBanking (Special Provisions) Act 2008).

In this regard, it is worth noting that certainaspects of the Banking Act, such as thecapital market arrangement protection inThe Banking Act 2009 (Restriction ofPartial Property Transfers) Order 2009,contain carve-outs for deposits. This is aclear indication that the authorities do notwant their powers in relation to deposits tobe fettered in any way, leaving them withthe greatest flexibility to transfer depositsout of a failing institution.

Following the application of the specialresolution regime under the Banking Act, itis likely that certain assets (and liabilities)will be left behind in a “bad bank”,although it appears unlikely on the basis ofprecedent that this would include retail

deposits. This is clearly demonstrated byThe Northern Rock plc Transfer Order2009 in the context of the split of NorthernRock (effective from the beginning of thisyear) where all the retail deposits weretransferred to the “good bank”.

Where certain assets (and liabilities) are leftbehind in the “bad bank”, the preferredinsolvency procedure for the “bad bank” isbank administration. If deposits were to beleft in a “bad bank” that entered bankadministration, it would seem likely thatthey would be sold out as a valuable assetduring the bank administration.

If an originator became insolvent before itsdeposits were transferred to a third partybank (which, arguably, would only happenin very limited circumstances), we note thatthe first objective of the bank insolvencyprocedure (which is specified in section 99of the Banking Act and which does takeprecedence over the second objective) isto ensure as soon as reasonablypracticable that each eligible depositor hasthe relevant account transferred to anotherfinancial institution or receives paymentfrom, or on behalf of, the FSCS. Inpractice, we believe that this will mean thateach Depositor will be protected in full fromone or other stated sources – and not thata Depositor will be partially covered.

If deposits of over £50,000 were to remainon deposit with an insolvent originator andbecome subject to the rules on set-off,notwithstanding the discussion above, it isconceivable that (notwithstanding anypurported set-off) a Depositor couldbecome subject to a claim from or onbehalf of a securitisation vehicle (of whichthey were previously unaware) for the fullamount of any debt owed by it as theability of the Depositor to set-off wouldmost likely be contested. Such claimscould lead to lengthy and complexlitigation, which the authorities are bound towant to avoid and the Depositors would beuncertain as to their forward position in the

meantime. It is also worth noting thatneither the Depositor nor the originator islikely to have an incentive to argue for set-off to apply in these circumstances (sincethe Depositor would likely rather haveaccess to their money in the currentaccount and the originator would preferthat the full amount of any receivableremained outstanding as they would haveaccess to excess cashflow and the fullamount of any “seller share” ina securitisation).

In short, our answer to the presentquestion as to whether the Banking Actprovides further comfort or mitigation tothe risk of set off above and beyond theFSCS, is that we would argue that it ishighly improbable that the authoritieswould allow deposits to remain in aninsolvent bank long enough to becomesubject to the uncertain application of therules on set-off. Accordingly, although it isarguable that some set-off risks arelegally present as a result of the BankingAct objectives and their application, thematerialisation of risks is very unlikely.

ConclusionIn our view, many existing transactionscurrently carry too much enhancementfor set-off risks in the light of the FSCSand Banking Act and the positivefeatures of the Banking Act have notbeen fully assimilated in the marketand particularly by rating agencies.We think there should be need forless enhancement for current accountset-off risk in future transactions. Onthat we note Moody’s paper entitledMoody’s Approach to QuantifyingSet-off Risk for Securitisation andCovered Bonds TransactionsOriginated by UK Deposit-TakingInstitutions published in December2009 and understand another agencyhas reached the same conclusion onspecific transactions.

9. A short analysis of theoperational risks of securitisationin relation to insolvent bankoriginators


In this article and the article entitled “TheFinancial Services Compensation Schemeand Banking Act 2009 – Dealing with theSet-Off Risks”, we examine when theseperceived risks occur (and indeed may beoverstated) and how they can bemitigated under the documentation andin practice.

We assume, for the purpose of thisarticle, that the structure in question is a“true sale” structure (i.e. not securedloans, originator trust or syntheticstructure) and the originator is a UK bank.

An indicative diagram For the purposes of this article and inrelation to the collections received fromthe underlying obligors, we assume twoscenarios, scenario one being theoriginating bank holding the collectionsitself (both in relation to the securitisedassets and non-securitised assets) andscenario two being the originating bankappointing a separate collection bank,which is a different legal entity to theoriginator, to hold the collections paid inby obligors (both in relation to the

securitised assets and non-securitisedassets).

The analysis of the different legal andoperational risks from these two scenariosis shown in the diagram below.

Scenario one – originator ascollection bank As shown in the diagram, we do not thinkthat there is a cash commingling issue inthis scenario. This is because in reality allbank accounts are simply ledger entries

Since the collapse of Lehman Brothers, rating agencies (and others including regulators)have put particular focus on the operational risks for a securitisation in the case of anoriginating bank insolvency, with particular focus on the “cliff risk” (i.e. originating bankovernight insolvency without being downgraded first). This has resulted in some recenttransactions being penalised as a result of the perceived risks of the insolvency of theoriginating bank (e.g. that collections may be lost at the insolvent banks which, as aresult, poses liquidity or credit risks for the securitisation).

New Horizons 50

Need for re-directionPlus effect ofnotice to Obligors

No Co-mingling issue

Co-mingling

Post-insolvencypayments fromobligors

Current Account Set Off

Obligor (Securitised Assets)

Originator (Self) SegregatedCollection Account

Obligor(Non Securitised)

SPV Bank Account

Originator (Diff) Non SegregatedCollection Account

Originator (Diff) SegregatedCollection Account

Originator (UK Bank)Obligor (Other Securitised Assets)(Non Securitised Assets)

Pay direct e.g. cheques, cash

Non automated payments

Automated payments

Non automated paymentse.g. cash, cheques

Automated paymentse.g. direct debits

Seller share payments (if relevant)

Non-securitised payments

Seller share payments

(if relevant)

Originator (Self) Non SegregatedCollection AccountNon-securitised payments

Non automated payments

Automated payments

and there is no “physical” account withsegregated or ring-fenced funds. It is tritelaw that a bank account is merely a claim– a chose in action – against the bank.

As there is no security over such accountnor will these book-entries be ring-fencedor secured by other available assets, onthe insolvency of the originator, the issuerwill become an unsecured creditor of theoriginator and will not have any proprietaryor security interest over the collectionsagainst the originator. In other words, inthis situation, it would be correct for somerating agencies to point out that certaincollections “credited” to the account andbelonging to the securitisation would be“lost”. However, what parties very oftenfail to analyse further is to what extent,and for how long, collections fromobligors will be lost to the securitisation.

Collections received from the underlyingobligors are usually allocated to customeraccounts on a daily basis and the originatortypically covenants, in the transactiondocuments, that it will transfer all collectionsin respect of the securitisation to the issueron the same or next Business Day. Thisessentially means that, on the overnightinsolvency of the originator, only thecollections that have been paid to theoriginator but have not been transferred tothe issuer as required under thetransaction documents will be lost.

A common misconception is that allcollections received post-insolvency of theoriginating bank will be lost. This is notcorrect. In practice, as soon as aninsolvency official is appointed in respectof an insolvent financial institution such asa bank, he will notify the debtor’s bankthat no further payments should bedebited to the debtor’s existing bankaccounts and that all receipts should,upon arrival in the existing account, beimmediately transferred to a new accountopened by the insolvency official. Where

the insolvency official receives fundswhich he is informed that belongbeneficially to another party, he’s likely toset those funds on one side and notdissipate them pending clarification of thefunds’ status. It is unlikely that theinsolvency official would immediately handover the funds to the alleged ‘true owner’until he has been satisfied on this score(which, as an aside, makes easyidentification of securitised assets andcollections important). Therefore, althoughthere may be a time delay during whichthe insolvency official tries to establish thebeneficial ownership of the funds, it wouldbe incorrect to say that the insolvencyofficial would somehow “snaffle” the fundsand place them in the general insolvencyestate of the originator and henceavailable to other creditors.

Typically in the securitisation documentswe would expect to see provisions to theeffect that upon originator insolvencyand/or ratings downgrade, the person towhom the equitable title to the assets hasbeen transferred – issuer on stand-alonetransactions and mortgages/receivablestrustee on master trust transactions –would be entitled to perfect the transfer ofequitable assignment by serving noticesto the underlying borrower, notifying them,inter alia, of the assignment of theportfolio by the originator or the issuer (ormortgages/receivables trustee) and thatpayments in respect of the underlyingassets shall straightaway be made to anaccount of the issuer or themortgages/receivables trustee instead ofthe originator. A power of attorney is alsotypically granted by the originator at theonset of the securitisation allowing theissuer (or mortgages/receivables trustee)to take any actions in the name of theoriginator. The expectation is that, uponinsolvency of the originator, the issuer orthe mortgages/receivables trustee wouldimmediately open a collection account

with a suitably rated third party bank intowhich all collections in respect of thesecuritisation will be paid into.

From a legal and operational perspectivetherefore, the key issue here is really oneof re-direction, i.e. how quickly can suchassignment and re-direction notice be putin place to practically “stop” theborrowers from continuing to makepayments the originator and how effectivewould such a re-direction be. This, inmany ways, depends on the paymentmethods of the underlying loans. InRMBS transactions, the majority of thepayments by the borrower would be byway of direct debit. On other unsecuredconsumer assets securitisations, thepayment methods will be more variedand may include direct debit, BACS,cheques, cash or debit card, bytelephone by debit card and via internet.In practice, how best to re-directpayments from the borrowers under thedifferent payment methods and thenecessary lead time for effecting suchre-direction are issues that are toodetailed for this article but which we willelaborate on in further publications.

Regardless of how the re-direction iseffected, in the context of an equitableassignment, it is established law that onceeach borrower has received anassignment notice and an instruction todischarge its payment obligations owingto the originator by paying into a differentaccount, its set-off rights will becrystallised and it will no longer be able to


51 New Horizons

“A commonmisconception is that allcollections received post-insolvency of theoriginating bank willbe lost”


New Horizons 52

claim independent set-off against theoriginator (although this does not affect anindependent set-off right which is“accrued due” or any equitable set-offright which may continue to exist), it willno longer be able to get good dischargeof its debts by continuing to pay theoriginator to the existing collectionaccount (Re Pawson’s Settlement,Higgins v. Pawson [1917] 1 Ch 541) and ifthe borrower mistakenly continues to payinto the existing collection account afterreceiving the notice, the borrower wouldhave to pay the amount due again intothe new account designated in the notice.

In our view the risk of “loss” can be furthermitigated for a couple of other reasons (sothat the risks discussed in the precedingparagraphs, though relevant, are largelytheoretical). First of all, the governmenthas taken wide powers particularlythrough the Banking Act to ensure such asituation does not develop as shown inthe Northern Rock collapse andnationalisation and transfer orders madein respect of Bradford & Bingley and theDunfermline Building Society (as to whichsee the article entitled “The FinancialServices Compensation Scheme andBanking Act 2009 – Dealing with the SetOff Risks”. Secondly, in practice borrowersare unlikely to continue making paymentsto the originator after the insolvency oforiginator until the position is clarifiedwhich will allow time for notice and re-direction to occur without further loss.

Scenario two – third partyholding collectionsAs shown in the diagram, in our view inthis scenario (i.e. that the collectionaccount bank holds the collections ofthe originator in respect of bothsecuritised debt and non-securitiseddebt), a commingling risk would existand associated with it, the risks oftracing. Both are discussed below. For a

limited period of time (which, asmentioned above, is not expected toexceed one or two Business Days) thatcollections remain in the collectionaccount of the originator, such moniesmay be commingled with other moniesof the originator and may cease to betraceable if the account is operated andbecomes overdrawn.

In a commingled collection account,although the collections in respect of thesecuritised assets are beneficially ownedby the Issuer, there is a risk that in theevent of the insolvency of the originator,any monies in the collection accountwhich are beneficially owned by the Issuerwould be held up in the insolvencyproceedings of the originator which mightprevent the Issuer from obtaining thosemonies on a timely basis from theoriginator. As a result of this risk, in anEnglish securitisation transaction it iscustomary for the originator to enter into adeclaration of trust over the moniesstanding to the credit of the collectionaccount which creates a trust over all themonies collected in favour of the issuer inrespect of assets beneficially owned bythe issuer (and in favour of itself over themonies collected in respect of the non-securitised assets). The existence of thistrust is typically notified to the collectionaccount bank.

The effect of the Issuer’s beneficial interestin the trust created by the originator willbe that, in the event of the insolvency ofthe originator, it will immediately be clearto the account bank that such monies willnot fall within the bankruptcy estate of theoriginator and the trustee of securitisationcan demonstrate to the liquidator oradministrator of the originator that suchmonies beneficially owned by issuershould be paid directly to the issuerwithout waiting for any insolvencyproceedings in respect of the originator tobe partially or fully concluded. Provided

that the declaration of trust satisfies therequired legal tests for a validlyconstituted trust, it would not be difficultfor the trustee to demonstrate that moniesbeneficially owned by the issuer shall bepaid directly to the issuer and for theaccount bank to accept this.

It is important to distinguish case lawrelating to where a trustee and abeneficiary lawfully mix trust and non-trustfunds of a trustee (in this case it would bethe originating bank) in an account, thetrust money is used by the trustee andbecomes the trustees’, subject only to apersonal obligation to repay.Consequently the “beneficiaries” underthe trust have no interest in the trustassets and are ranked as unsecuredcreditors of the trustee (SpaceInvestments Limited v Canadian ImperialIssuer of Commerce Trust Co (Bahamas)Limited [1986] 1 W.L.R 1072).

In our view this case relates to situationswhere the beneficiary expressly allows thetrustee to use the monies for its ownpurposes. This is different insecuritisations when the declaration oftrust would normally contain restrictionson the originator’s ability to withdraw trustmonies belonging to the beneficiariesfrom the collection account. Theserestrictions would typically include, forinstance, that the originator may onlymake withdrawals from the collectionaccount in accordance with the servicingagreement in the amounts to which theoriginator is entitled pursuant to thedeclaration of trust.

If these restrictions are complied with,Space Investments (supra) isdistinguished on the basis that thebeneficiary in that case had expresslyallowed the trustee, under the trustinstrument, to generally appropriate trustmoney to another account where it couldbe used for its own purposes.

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Where the tracing remedy is available, itcan be applied against a mixed fund in abank account to the extent that the trustfunds can still be shown to be there. Itshould be noted that if the account fallsbelow that sum, that part of the trustmoney is deemed to have been spent(Roscoe v Winder [1915] 1 Ch.62).Accordingly, the issuer would only ever beable to recover money from the collectionaccount relating to the securitisation tothe extent that it is actually there. Wherean account is in overdraft, tracing cannotbe used by a beneficiary (re Diplock[1948] CH 456 and re Goldcorp ExchangeLtd [1995] 1AC 74), since one cannottrace through a non-existent fund.

In the same way as under scenario one,once the originator is insolvent, noticeswill be sent to the borrowers re-directingthem to make payments to an account ofthe issuer (or mortgages trustee orreceivables trustee on master trusts). There-direction process and effectivenesswould be broadly similar to scenario one.While this is strictly not necessary as

result of the continuation of the trust, itwould make administration of collectionseasier not least as involvement of aninsolvency officer would be removed butalso because a replacement servicer islikely to wish to have its ownarrangements established.

We would also stress that, in our view,although in scenario two the declarationof trust by the originator coupled with therestrictions on the ability of the originatorto deal with the collections – if compliedwith in practice - is capable of mitigatingthe commingling and tracing risks, there

is no real benefit for such declaration oftrust in scenario one. As mentionedabove, in scenario one, there will be nocash in a physical collection account(other than book entries) and a trustdeclared over it would, in reality, be overthe originator’s chose in action whichdoes not create any valuable proprietaryinterest for the benefit of the issuer asthe claim will be against an insolventoriginator. As mentioned above, the realmitigant in scenario one therefore lies inthe speed with which the re-directionprocess can be carried out.

ConclusionIn our view, the operational risk on securitisations in the context of originating bankinsolvency is an area that requires more focus. In this respect, sequencing of issues isimportant for analysis, both pre-insolvency, at the point of insolvency and duringinsolvency. We also believe that the practical impact of the Banking Act needs greaterassimilation. Nevertheless, it is clear that the whole area of operational risk on banksecuritisations will continue to be the focus of rating agencies and regulators. We areconducting more detailed analysis in relation to these issues and will share that withthe market when available.

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10. Case study of the bankruptcy ofa Dutch retail bank – testing thewaters for Dutch securitisations

History and bankruptcyof DSBDSB’s history goes back to 1975. It hasmainly been active as a consumer creditand mortgage loan provider and as aconsumer credit, mortgage loan andinsurance intermediary. It obtained aDutch banking licence in 2005 afterwhich it further broadened its retailbanking operations. DSB’s shares are allheld by the holding company of DSB’sfounder, Mr. Scheringa. Mr. Scheringa’sholding company – which was declaredbankrupt shortly after DSB’s bankruptcy –also holds shares in a number of othercompanies with various businessactivities, including the insurancebusiness. Mr. Scheringa was also chiefexecutive officer of DSB.

In the months prior to its bankruptcy,DSB had been criticised in the media forits sales methods in respect of loans andrelated savings and insurance products.This criticism primarily focused on allegedbreaches of a duty of care by DSBtowards its customers, in particular inrelation to over-crediting of customersand lack of transparency of costs relatingto its insurance products. A number ofgroups holding themselves out asrepresentatives of aggrieved DSBcustomers voiced concerns. In earlyOctober 2009 it appeared that whilst onegroup was close to a settlementarrangement with DSB on behalf of theDSB customers it represented, one othergroup publicly confirmed that it no longer

wished to participate in settlementdiscussions with DSB and – through itsrepresentative – publicly hinted that DSBcustomers may have gotten a better dealif DSB became subject to bankruptcyproceedings and settlement discussionswere held with its bankruptcy receivers. Ittherefore advised customers to withdrawtheir deposits.

The Dutch government has ordered aninvestigation into the circumstances andfacts which led to DSB’s bankruptcy theresults of which are not yet published.However, it is widely believed that acombination of DSB’s alleged aggressivesales methods and the advice to withdrawdeposits resulting in public attention inrespect of DSB’s capital and liquidityposition as well as rumours that the DutchCentral Bank was taking action to declareemergency regulations (noodregeling)pursuant to the Dutch FinancialSupervision Act (Wet op het financieeltoezicht) in respect of DSB, led to a run onthe bank. A number of rescue operationswere proposed in the short time available,which would have involved the potentialparticipation by other Dutch banks, butthey were unsuccessful. The Dutch CentralBank therefore requested the applicationof emergency regulations in respect ofDSB. The Dutch Central Bank was of theview that the solvency and liquidityposition of DSB showed signs of adangerous trend with no reasonableprospect of improvement, which is one ofthe tests for which a Dutch court cansubject a bank to emergency regulations.

Whilst the court confirmed in its ruling of11 October 2009 that DSB’s liquidityposition was very disturbing, it initiallyrejected such request. However, thepublicity and rumours surrounding theproceedings resulted in a further decreaseof DSB’s solvency and liquidity position.This resulted in an immediate secondrequest by the Dutch Central Bank forapplication of emergency regulations. Thecourt declared such emergencyregulations on 12 October 2009.

A few days later the court-appointedreceivers requested that the court convertthe emergency regulations intobankruptcy proceedings on the basis ofDSB’s negative equity position andbecause there was no prospect of acontinuation of DSB as a going concern.The court, however, allowed Mr.Scheringa and the receivers a limitedperiod of time to investigate whetherthere could be ways to avoid bankruptcy.No satisfactory solution was found andDSB was declared bankrupt on 19October 2009. As a consequence ofDSB’s bankruptcy its banking licence wasrevoked. However, also taking intoaccount DSB’s continuing servicing ofsecuritised and unsecuritised loanportfolios, activities which require alicence under the Dutch FinancialSupervision Act, DSB is neverthelessregarded as a licensed bank during theprocess of liquidation.

At the time of its bankruptcy, DSB had anumber of outstanding securitisations. Its

Although there have been a number of banks in the Netherlands that have becomesubject to bankruptcy proceedings, until recently this did not involve banks that hadsecuritised large parts of their assets. In October 2009, however, DSB Bank N.V.(“DSB”), a Dutch retail bank that had securitised large parts of its residential mortgageloan and consumer credit loan portfolios (under the names Chapel, Convent, Domeand Monastery) became subject to bankruptcy. This article focuses on the impact sofar of DSB’s bankruptcy on its securitisations. Our observations are based on publiclyavailable information, including press articles, relevant public offering documentationand published bankruptcy reports up to the middle of May 2010.

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most recent public (but retained)securitisation closed in April 2009.

Without purporting to be complete, wewill now describe in the belowparagraphs the impact that DSB’sbankruptcy has had on various matters(including assignment notification,servicing, interest rate resets, set-off andswap terminations) which are integral tothe structuring and rating of aDutch securitisation.

Impact of DSB’s bankruptcyon DSB securitisationsNotification of assignment

The majority of DSB’s securitised loanreceivables have been transferred to atypical securitisation special purposevehicle (“SPV”) by way of silentassignment, which is a common transfermethod used in Dutch securitisations. Asa consequence of silent assignment, aslong as no notification has taken place,any payments made by the debtors underthe transferred receivables must continueto be made to DSB. In respect ofpayments so made prior to DSB’sbankruptcy taking effect, the SPV will bean ordinary, non-preferred creditor. Inrespect of post-bankruptcy payments, theSPV will be a creditor of DSB’s estate,and will in principle receive payment priorto creditors with bankruptcy claims, butafter preferred creditors of the estate.

As is customary in Dutchsecuritisations, the application ofemergency regulations, moratorium of

payments or bankruptcy of an originatorconstitutes an assignment notificationevent. Upon the occurrence of suchevent, the SPV and/or security trusteemay notify the borrowers of theassignment of the receivables to theSPV unless the rating agencies confirmthat not giving such notification will notresult in rating downgrades of the notesissued in the securitisation. Theconsequence of such notification wouldtypically be that the principal andincome proceeds of the receivables aresegregated from the originator and aredirectly paid by the borrowers intotransaction accounts of the SPV orsecurity trustee.

Although DSB was subject toemergency regulations and is nowsubject to bankruptcy, notification of theassignment of receivables to the variousSPVs has not been given to the

borrowers. Therefore borrowers canonly discharge their debts by makingpayments directly to DSB. The fact thatno such notification has been givenresults from arrangements that havebeen made between DSB’s receiversand the various SPVs and securitytrustees to the effect that suchreceivables proceeds are on-paid by thereceivers to the SPVs.

Such arrangements may have been putin place to address concerns that suchcustomers would suspend payments inrespect of both securitised andunsecuritised receivables upon suchnotification, since such customers mayfear that any damages claims (or partsthereof) that they may have inconnection with alleged misselling claimsmight remain unpaid in DSB’sbankruptcy. Another reason for thereceivers agreeing to such arrangementsmay have been that DSB is likely to beholding subordinated or other first losspositions in one or more of itssecuritisations as a result of which non-payment by customers may ultimatelyhave a negative effect on DSB’s estate.The perception that maintaining DSB asexisting servicer would reduce paymentsuspensions or losses is supported bythe fact that in the first month afterDSB’s bankruptcy ninety per cent. of theborrowers had continued their monthlypayments and more than fifty per cent.had given new direct debit instructions.

It therefore follows that events thatconstitute assignment notificationevents under securitisations may notimmediately result in actual notificationto borrowers of the assignment, inparticular if it is believed that suchnotification is likely to result in cashflowdisruptions. However, in circumstanceswhere receivers would not have beenwilling to on-pay future receivables


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“DSB had been criticisedin the media for its salesmethods in respect ofloans and related savingsand insurance products”

Prior to 2004, under Dutch law atransfer by way of silent assignmentwas not possible. In the DSBsecuritisations until 2004, a conditionalassignment structure was used,meaning that the transfer ofreceivables would not be perfecteduntil notification of the assignment isgiven to the debtors, to avoid thatdebtors would have to be notified atinception. To address that suchassignment may not be validlyperfected upon insolvency thereceivables have amongst other thingsbeen pledged to the relevant SPV byway of an undisclosed pledge assecurity for DSB’s obligations underthe relevant transaction documents. Inthis section we will only focus onsecuritisations involving silentassignment of receivables albeit thatthe analysis is more or less similar fortransactions involving silent pledges.

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cashflows, notification may have beenthe only appropriate remedy to protectsuch cashflows.

Servicing of receivables

One would typically expect servicingagreements in securitisations to includeprovisions allowing the SPV and/orsecurity trustee to terminate theservicing arrangements early with theinitial servicer in the event of defaulton the part of such servicer, includingits bankruptcy.

In the DSB securitisations, servicing ofsecuritised and unsecuritised loanscontinues to be performed by DSB.Therefore, further arrangements havebeen made by the receivers with thevarious SPVs and security trustees withrespect to the continuation of servicingactivities as otherwise it could beexpected that such initial servicingarrangements would have beenterminated early as a result of DSB’sbankruptcy. We understand that thereceivers are currently investigating a re-launch of DSB’s servicing business unitin a strategic co-operation, if necessary,with a reputable third party in order tocontinue further stabilising loanservicing and creating a separateservicing platform.

In particular in respect of more recentsecuritisations, it would also becommon for such transactions toinclude back-up servicingarrangements, such as covenants forthe relevant parties to appoint back-upservicers upon termination of the initialservicing arrangements or theappointment of a back-up serviceron the initial closing date of thetransaction which appointment isconditional upon certain eventsoccurring in respect of theinitial servicer.

We understand that back-up servicershave only been appointed with respectto some, but not all, of DSB’ssecuritisations or are in the process ofbeing appointed. The reason for notappointing back-up servicers on a largescale on the DSB securitisations mayvery well be that there is no immediatenecessity for such appointment, takinginto account the receivables proceedsdistribution and servicing arrangementsmade between the receivers on the onehand and the SPVs and securitytrustees on the other. It might also implythat from an operational perspective (forexample, due to IT incompatibilityand/or reporting systems, use ofdiffering servicing manuals, dataprotection issues or otherwise) it maynot be straightforward for third partyservicers to replace existing servicers.We have seen in other unrelatedsecuritisations that it can be difficult tofind third party servicers for reasons setout above or due to the fact that thereare only a handful of parties that areeligible, capable or interested in takingon such roles.

In their most recent bankruptcyreport, the receivers indicated thatfrom an efficiency and continuityperspective, they wish to appoint asingle back-up servicer for allsecuritised and unsecuritisedportfolios. The report also states thatnone of the parties which are currently

involved has expressed a willingness totake on the back-up servicing role forthe entire portfolio.

It follows that, notwithstanding that therelevant initial servicing arrangementsmay allow for early terminationremedies, at least for the initial periodfollowing DSB’s bankruptcy, DSBcontinuing its servicing activitiesreduces the risk of cashflow disruptions.

Interest rate reset rights

Dutch mortgage loans traditionally havea maturity of 30 years whilst the interestthereon is either based on a variablerate or a fixed rate. The borrower mayusually opt to set the interest rate forshorter periods (e.g. 5, 10, 15 or 20years) than the maturity of the mortgageloan. As a result, the interest rate is tobe reset at the end of the relevantperiod. It is uncertain under Dutch lawwhether an interest reset right (as anancillary right) will transfer to thetransferee upon the assignment of therelevant (loan) receivable to thetransferee. If in a securitisation suchinterest reset right would not transfer tothe SPV and would not terminateautomatically as a result of suchtransfer, it would probably remain withthe transferor (in this case, DSB)meaning that the co-operation of thereceivers would be required to resetsuch interest rates. This is usually aconcern for rating agencies and third


“The perception that maintaining DSB as existingservicer would reduce payment suspensions or losses issupported by the fact that in the first month after DSB’sbankruptcy ninety per cent. of the borrowers hadcontinued their monthly payments and more than fiftyper cent. had given new direct debit instructions”

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party swap providers given that, incircumstances where there would be anincentive for the receivers to reset therates below market level, this couldresult in losses for investors on thenotes or the swap providers. Suchlosses are usually not taken intoaccount when structuring thetransaction and/or entering into therelevant swap agreement.

Whilst we believe that there are goodarguments for the related interest ratereset right to follow a receivable uponits transfer, we also believe that wheresuch right does not follow, a receiverwho would, contrary to the instructionsof the SPV (where such instructionswould typically be at the discretion ofthe SPV but subject to the terms andconditions of the loan contracts), set theinterest rates below market levelswithout there being a valid reason to doso, would expose himself to personalliability in respect of the SPV and otherinterested parties on the basis ofcontractual breach or tort. We wouldtherefore expect receivers to act in acommercially reasonable and prudentmanner in such matters.

The servicing arrangements for thevarious DSB securitisations areexpected to provide that the originatoras initial servicer is responsible forsetting the interest rates from time totime in respect of the securitisedloans although it cannot be excludedthat third party swap providers involvedin a securitisation may have certainrights under the documentation tostipulate minimum interest rates. Weassume that, as part of the agreedreceivables proceeds distribution andservicing arrangements, DSB willcontinue to reset the interest rates forso long as it remains the servicer of thesecuritised receivables.

Set-off rights of borrowers

Notwithstanding the assignment andpledge of receivables to the variousSPVs and security trustees,respectively, the borrowers may beentitled to set-off the relevantreceivable against a claim they mayhave vis-à-vis DSB (if any), such ascounterclaims resulting from a currentaccount relationship and, depending onthe circumstances, counterclaimsresulting from a deposit made by aborrower. In the absence of contractualprovisions expanding statutory set-offpossibilities, mutuality of claims is oneof the requirements for set-off to beallowed: the parties, mutually, must beeach other’s creditor and debtor.Following an assignment of a receivableby DSB to the relevant SPV, DSB wouldno longer be the creditor of thereceivable. However, so long as theassignment of the receivable by DSB tothe relevant SPV has not been notifiedto the relevant borrower, the borrowerremains entitled to set-off thereceivable as if no assignment hadtaken place.

After notification of the assignment orpledge, the relevant borrower can stillinvoke set-off pursuant to the relevantprovisions of the Dutch Civil Code(Burgerlijk Wetboek). On the basis ofsuch provisions a borrower can invokeset-off against the relevant SPV asassignee (and the relevant securitytrustee as pledgee) if the borrower’sclaim vis-à-vis DSB (if any) stems fromthe same legal relationship as thereceivable or became due and payable

before the notification. Furthermore, it ispossible that (on the basis of ananalogous interpretation of suchprovisions) a borrower will be entitled toinvoke set-off rights against the SPV ifprior to the notification, the borrowerwas either entitled to invoke set-offrights against DSB (for example, on thebasis of the Dutch Bankruptcy Act) orhad a justified expectation that hewould be entitled to such set-off againstDSB. Where any mortgage loanorigination documentation of DSB wouldprovide for a waiver by the borrower ofhis rights of set-off vis-à-vis DSB, suchwaiver could be avoided pursuant toDutch contract law and may thereforenot be enforceable.

In relation to DSB’s bankruptcy it islikely that set-off questions will arise inconnection with amongst other things(a) claims of borrowers under savingsdeposits and the provisions of theDutch deposit-guarantee scheme(which is based on European Directive94/19/EC on Deposit GuaranteeSchemes) and (b) any potential claimsfor damages by borrowers in relationto alleged breaches of duty of careby DSB.

As regards (a), certain deposits held bycustomers with DSB were covered bythe Dutch deposit-guarantee scheme.The Dutch Financial Supervision Actand its relevant subordinatedregulations and decrees are based onthe presumption that deposit amountsheld by customers with the insolventbank will be set-off against any amountowed to such bank by its customers

“The receivers indicated that from an efficiency andcontinuity perspective, they wish to appoint a singleback-up servicer for all securitised and unsecuritisedportfolios”

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(under loans or otherwise). However, weunderstand that no such set-off hasbeen applied in DSB’s bankruptcy andthat payments have been made by theDutch Central Bank to customers up toa maximum amount of EUR 100,000per customer (as currently prescribedby the Dutch deposit-guaranteesystem regulations).

As regards (b), if such claims fordamages prove to be successful (eitheron the basis of court judgment orsettlement arrangements with thereceivers) borrowers would be entitledto invoke set-off in respect of suchclaims against amounts owed by themunder the relevant loans (whether or notsecuritised). We understand that certaincustomers have expressed theirintention to set-off such claims fordamages and that the receivers haveinformed such customers that if it isestablished that DSB has breached itsduty of care towards such customersand such customers have resultingclaims for damages, the receivers willtake this into account in order todecrease the debts owed by suchcustomers to DSB.

If set-off is applied this may have anegative impact on the SPVs (and theirnoteholders and other creditors) incircumstances where DSB’s bankruptestate would not be sufficient toreimburse the SPVs for amounts so set-off since the SPVs will be ordinarycreditors for such reimbursementamounts. If set-off is not applied, forexample, because actual pay-outs aremade to customers under the Dutchdeposit-guarantee scheme, this mayhave a positive impact for the SPVssince in respect of their claims againstDSB for proceeds received, the SPVs willbe creditors of the bankrupt estate andwill therefore have a preferred position as

regards ordinary creditors. Obviously, theapplication of set-off would have apositive impact on the position of theparticipating banks in the Dutch deposit-guarantee scheme as their mandatorypayment contributions under the Dutchdeposit-guarantee scheme woulddecrease as a result of such set-off.

More generally, taking into account thenegative impact that the failure to applyset-off may have on banks participatingin the Dutch deposit-guarantee system(and the positive impact this may havefor SPVs) and the fact that set-off risk iscommonly disclosed and mitigatedthrough credit enhancement features insecuritisations, it would not besurprising if in the future Dutch bankswere to take the initiative in lobbying forlegislative reforms in this regard.

Swap transactionsAs is common in securitisations whereincome of securitised assets and otherassets of the SPV fluctuate or do notmatch the fluctuating interest rateobligations of the SPVs, swaptransactions were entered into underthe various DSB securitisations.

Since DSB did not have an official creditrating, it was not eligible to act as swapprovider on its securitisations. Weunderstand that third party swapproviders with the minimum requiredcredit ratings entered into front swapswith the SPVs in DSB’s securitisationsand that such swap providers in turnentered into back to back swaps withDSB to ensure that the economicbenefits and risks relating to interest

rate mismatches of the SPVs’ assetsand liabilities were transferred to DSB.We also understand that all such backto back swaps were terminated early asa result of DSB’s bankruptcy. Inprinciple, the early termination of theback to back swaps did not impact onthe front swaps.

As was the case in the securitisationmarkets generally, securitisation basisrate swaps and in particular the back toback swaps and related collateralarrangements – are somewhatbespoke. This may have made itdifficult for such swap providers toobtain and/or determine replacementvalues or to determine their losses. Itremains to be seen whether any suchdeterminations, valuations and/or anyearly termination payments claimedfrom DSB by “in-the-money” swapproviders will be challenged by thereceivers. In this respect, one of thebankruptcy reports states that thereceivers will consult with the swapproviders in relation to relevantdeterminations and valuations whichindicates that the receivers are notnecessarily in agreement with suchdeterminations and valuations.

Impact of DSB’s bankruptcyon rated DSBsecuritisationsAs far as we are aware, DSB’sbankruptcy did not impact the creditratings assigned by Standard & Poorsto notes issued by the various SPVs inDSB’s securitisations. However, within a

“If set-off is applied this may have a negative impact onthe SPVs (and their noteholders and other creditors) incircumstances where DSB’s bankrupt estate would notbe sufficient to reimburse the SPVs for amounts set-off”

61 New Horizons


month of DSB’s bankruptcy, Moody’sdowngraded the notes in the variousChapel and Monastery securitisationsby two notches from AAA to Aa2. Inaddition, in March 2010 Moody’s putthe notes rated by it on negativeoutlook and downgraded the varioussubordinated notes in thesesecuritisations with a then currentrating of high B to a low B andsubordinated notes with a then currentrating of low B to a high C. Weunderstand that the main reasons forsuch downgrades were fears ofcashflow disruptions caused byborrower defaults resulting in portfoliolosses, and that noteholders would notbe informed in a timely manner inrespect of any such disruptions.

ConclusionWhilst it is expected that DSB’s bankruptcy will continue for at least a couple of yearsand therefore the position of participants in DSB’s securitisations, including SPVs,may in many respects be uncertain, so far it appears that not all of the risks andevents that market participants and rating agencies would typically expect havematerialised when structuring and rating a Dutch securitisation. It has also becomeclear in the case of DSB that, where the transaction documentation would typicallyprovide for certain contractual remedies in the case of certain insolvency relatedevents relating to an originator or servicer, such remedies are not necessarilyimmediately pursued by the SPVs and security trustees.

The reasons for this may very well be that where an originator has unsecuritisedportfolios or subordinated securitised positions on its balance sheet, the interests ofthe receivers may initially be aligned with those of the SPVs and security trustees. Byavoiding confusion and misunderstandings by borrowers, cashflow disruptions are, atleast in the period immediately following the imposition of bankruptcy proceedings,expected to be minimised. Such confusion and misunderstandings can be avoidedby sending clear messages to customers and, particularly in respect of borrowerswhose loans have been securitised in different transactions, by having one singlecustomer facing contact servicing the loans.

Nevertheless, it remains to be seen to what extent any application of set-off byborrowers may have an impact on the SPVs and security trustees, also bearing inmind that, should any damages claims for duty of care breaches prove to besuccessful, the SPVs and security trustees will have limited protection measuresavailable to minimise losses on the securitised portfolios. This is due to the fact thatany triggered indemnity or reimbursement obligations of DSB under thesecuritisations will be of little or no value to the SPVs and security trustees whereDSB’s bankrupt estate would be insufficient to meet such claims of the SPVs andsecurity trustees as ordinary creditors. Third party investors in DSB’s securitisationswill need to continue to hope that any such potential losses will not exceed anyretained positions held by DSB.

New Horizons 62


11. Perpetually deprived of using“flip” provisions?

Perpetual – where arewe now?

As discussed in more detail in ourprevious article, all three English Court ofAppeal Judges declined to apply the anti-deprivation principle to the facts.However, they differed on the basis onwhich they did so. The variance was dueto Patten LJ’s preparedness to excludesecured waterfall arrangements entirelyfrom the scope of the principle, asopposed to the reasoning of LordNeuberger MR and Longmore LJ, whodecided that the application of the anti-deprivation principle should be decidedon a case by case basis. With regard towhy he chose to diverge from Patten LJ’sassessment, Lord Neuberger MR ratherconfusingly says “while that view [ofPatten LJ] may well indeed be right, Iprefer to rest my conclusion in this caseon the more limited ground that inaddition to the facts relied on by PattenLJ the assets over which the chargeexists were acquired with moneyprovided by the chargee in whose favourthe flip operates, and that the flip wasincluded merely to ensure … that thechargee is repaid out of those assets allthat he provided (together with interest)before the company receives any moneyfrom those assets pursuant to itscharge”1. This reasoning of LordNeuberger MR has complicated the way

in which the anti-deprivation principle isaddressed in legal opinions and inprospectus risk factors.

In England, leave to appeal the decisionof the Court of Appeal was granted on26 March 2010 and the English SupremeCourt is expected to hear the case duringspring 2011.

In the US, Judge Peck published hisstatement of the law on 25 January2010, which was “directly at odds withthe judgment of the English Courts”2.Judge Peck found that the flip provisiondid in fact contravene the ipso factoprovisions of the US Bankruptcy Code.In reaching this conclusion, Judge Peckgave a broad interpretation to therelevant provisions, finding that theyapplied to any provision whichpurported to vary contractual rights onthe commencement of any bankruptcycase under Chapter 11, not merely abankruptcy case involving the insolventswap counterparty. While Judge Peckacknowledged that there would need tobe some connection between the casecommenced under Chapter 11 and theparties in question, he held that thecommencement of a case underChapter 11 in respect of LBSF’s parententity was a sufficiently close

At the time our last article on this topic, “OTC Derivatives in structured debttransactions” was published as part of our New Beginnings publication, the Court ofAppeal judgment in the Perpetual Trustee Company Limited v BNY CorporateTrustee Services [2009] EWCA Civ 1160 case had just been handed down and therating agencies had initially reacted by requiring legal opinions to addressspecifically the enforceability of priority of payment provisions in securitisationtransactions. We had gazed into our crystal ball and speculated on how thepending decision of the US Bankruptcy Court on the same issue might result in USswap counterparties being excluded from the market in Europe, unless actingthrough locally incorporated subsidiaries.

This aim of this article is to provide an overview of the current state of the Perpetuallitigation, to consider the rating agencies’ reactions and to describe some of thesolutions and market developments resulting from the litigation.

New Horizons 64

1 See paragraph 67 of the Court of Appeal judgment [2009] EWCA Civ 11602 See page 15 of the Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd., Ch. 11 Case No. 08-13555. Adv. No. 09-01242 (Jan. 25, 2010).


The Perpetual case concerned aDelaware incorporated Lehman entity(“LBSF”) which entered into a swap witha special purpose issuer of notes underwhich LBSF paid sums equivalent to thesums payable by the issuer to thenoteholders under the notes in exchangefor sums equal to the yield on thecollateral purchased with the subscriptionmoneys from the notes and held by theissuer. Payments due from the issuerwere secured in favour of the noteholdersand LBSF (amongst others) and subjectto a priority of payment waterfall whichentitled LBSF to receive payment aheadof the noteholders prior to the occurrenceof an event of default in respect of LBSF(which included related insolvencyevents), but following an event of defaultranking LBSF behind the noteholders.This change in the priorities is colloquiallyreferred to as the “flip provision”.Following the collapse of the LehmanGroup, payments due to the noteholderswere not made and Perpetual Trustee, asnoteholder, issued claims against BNYCorporate Trustee Services Limited (the“Security Trustee”), seeking orders thatthe Security Trustee procure therealisation of the collateral held as securityin Perpetual’s favour and in priority to theclaims of LBSF under the swap.

connection. As a result of this, it did notmatter whether the flip provision wastriggered prior to the onset ofinsolvency in respect of LBSF; it stillcontravened the ipso facto provision. Ineither case, the flip took effect upon thecommencement of a case underChapter 11 and was thusunenforceable. Judge Peck also foundthat the flip provision did not form partof the swap agreement itself, andtherefore could not be protected by the‘safe harbour’ provisions of the USBankruptcy Code which permit thetermination of various derivativecontracts notwithstanding thecommencement of Chapter 11proceedings. However, this decision hasstill not been memorialised and so istechnically not a court judgement. Thisis a feature of the US court system,which observers may find slightly odd,particularly as no application for appealagainst the decision evidenced in JudgePeck’s statement can be made until thejudgment is memorialised.

Recently two motions have been filed,one of which has been granted, whichwill impact the course of the Perpetuallitigation in the US. First, on 22 April2010, the court granted the motion filedby certain Lehman entities in the USBankruptcy Court for permission topurchase, without further court approval,notes (or participations in notes) issuedby special purpose issuers which haveone of the relevant US Lehman entities(including LBSF) as a counterparty. ThePerpetual litigation was referred to in themotion and the implication of this motion

is that Lehman will seek to purchase thenotes in the Perpetual case in anattempt to halt the litigation. Second, inMay 2010, BNY Corporate TrusteeServices Limited (“BNY”) requested thatthe US Bankruptcy court enter an orderin respect of Judge Peck’s previousstatement of law. BNY noted theBankruptcy Court’s desire to coordinatethe US Decision with the ruling of theEnglish courts regarding litigationbetween LBSF and Perpetual (the solenoteholder in the transaction). However,BNY asserted that as it has been morethan three months since the Courtissued its decision the Court shouldenter an order memorializing the USDecision so that the “inevitable andlengthy U.S. appellate process can atleast begin” so that any latercoordination reflects the “confirmedjudgment of the courts at all levels of thetwo jurisdictions.” In the alternative, BNYrequested that the Court grantreargument of the parties’ cross-motionsfor summary judgment and enter adeclaratory judgment in BNY’s favour or,as warranted, order targeted discoveryand an evidentiary hearing to resolve thecase.� In a recent status conferenceJudge Peck asked the parties to agree adate falling after 16 June 2010 on whichto hold the hearing.

Rating agency reaction tothe litigation in the USThere has been much marketcommentary on the merits of JudgePeck’s decision from a US Bankruptcylaw perspective but we will confineourselves to considering the impact ofthe decision on non-US structureddebt transactions.

When Judge Peck’s decision was firstpublished the initial reaction from therating agencies was dramatic. There were

indications that the rating of structuredfinance notes would be capped at therating of the swap counterparty not onlyin the case of a US incorporatedcounterparty but also in respect of non-US subsidiaries of US entities where thesubsidiary acts as swap counterparty in arated deal.

The rating agencies’ response wasviewed by many market participants asan over-reaction and did not take intoaccount the protections already builtinto their swap counterparty criteriawhich are intended to avoid the issuerin a structured deal facing an insolventswap countparty.

As we explained in our briefing “Anti-deprivation: what next for the UKStructured Debt Market?”, for AAA/Aaa-rated securitisations the rating agenciesrequire that swap counterparties mustcomply with their counterparty criteriawhich include requirements as to themaintenance of certain short-term and/orlong-term ratings of the swapcounterparty. In the event that a swapcounterparty is downgraded, ratingagency criteria require certain actions tobe taken, for example, the transfer of theswap transaction to a party meeting thecriteria, the posting of collateral or theprovision of a suitably rated guarantee. Insimple terms, the inclusion of the transfer,collateralisation or guaranteerequirements enable each rating agencyto satisfy itself that the risk of theinsolvency of a swap counterpartyaffecting the securitisation cash-flows issufficiently remote that it should notprevent the rating agency from awardinga AAA rating to the relevant notes. In theimmediate aftermath of the USBankruptcy Court’s decision, RatingAgencies requested additional opinions toaddress the cross-border enforceabilityissues raised by the case but these


65 New Horizons

“The rating agencies’response was viewed bymany market participantsas an over-reaction”

New Horizons 66

requests cut across their existing swapcounterparty criteria, which permit thesolvency of the entity to be assumed. It isunclear what such opinions added asthere were already mechanisms fordealing with counterparty default andnon-compliance with criteria.

At one point some rating agencies werenot only requesting opinions expresslyaddressing the enforceability of thepayment priorities provisions underEnglish law following the insolvency of theswap counterparty but also asking fornon-consolidation opinions from both aUS and English insolvency perspective.These opinions were to confirm that,following the insolvency of the US parentof an English incorporated subsidiary, anyinsolvency proceedings in respect of thesubsidiary would not be consolidatedwith that of its parent. While theseopinion requests could be met from anEnglish law, perspective, from a USperspective they posed a number ofdifficulties. As a result of the Lehmaninsolvency process where locallyincorporated subsidiaries of a US parenthave been subject to local insolvencyproceedings, rating agencies now seemto be rating on the assumption thatsubsidiaries will file for insolvency locallyand accordingly, the rating agencies havebeen satisfied with an English non-consolidation opinion only. The ratingagencies should stand by their ratingscriteria, in particular the replacementtriggers and, on that basis, there shouldbe no need for such an opinion.

Structural changes - can aclear distinction be drawnbased on the jurisdiction ofincorporation of thecounterparty?The rating agencies are still developingtheir policies in response to the US

Bankruptcy Court’s judgment inPerpetual. What is clear is that the ratingagencies are distinguishing betweentransactions they view as non-US –involving English assets, an Englishsecurity trustee and an Englishincorporated swap provider, for example– and transactions which have a USelement. Trying to define “US element”remains difficult as the rating agencyviews are changing. However, what canbe said is that the parameters have beenset wider than merely that the swapcounterparty is incorporated in the US,for example, to include Englishincorporated counterparties with a USparent (either as a direct parent or furtherup the ownership chain).

In respect of counterparties with no USparent (as a result of either direct orindirect ownership), there has been nochange in the structuring of transactions.Termination payments to the counterpartyare still subordinated following thecounterparty’s default.

In respect of locally incorporatedsubsidiaries of a US parent company (asa result of either direct or indirectownership), as discussed above, theagencies seem to be assuming thatlocal subsidiaries will file for insolvencylocally. Logically, this would mean that,provided a legal opinion that anypayment priorities are valid andenforceable in the jurisdiction ofincorporation of the relevant counterparty,the rating agencies should be able to ratestructures with payment priorities withoutany structural adaptation. However,transactions involving non-USsubsidiaries of US parents are still beingforced to be restructured.

Following the Bankruptcy Court’sdecision, US counterparties wereeffectively vetoed by the rating agencies.It seems that any transaction with a UScounterparty which has subordinationprovisions will be capped at the rating ofthe counterparty. Practically, though, itseems unlikely that European issuers willbe willing to mandate arrangers which areunable to provide at least a non-USincorporated subsidiary of a US bank toact as swap counterparty.

Structural changes - a bigshift or merely tinkeringwith existing structures?In some respects, simple changes havebeen made to all transactions.Independent of the changes made toswap structures as a result of thePerpetual litigation, there is a generaltrend of deconstructing swaps. Aspricing of a particular swap is broadlyspeaking a function of its liquidity andsimpler swaps are more liquid, thistrend may alleviate some of the pricingpressure on certain swap transactions.However, breaking more complexswaps into their constituent parts is nota structural solution to the issues raisedin Perpetual.

In response to the Perpetual litigation,transactions which include a flip provisionwill now also include a risk factor in theprospectus explaining the potentialimpact of the Perpetual decision on therepayment of the Noteholders inaccordance with the transactionwaterfalls. It is also possible to minimisethe potential impact of the anti-deprivation principle (at least from anEnglish law perspective) through careful


“The rating agencies should stand by their ratingscriteria, in particular the replacement triggers”

67 New Horizons


drafting of the transaction documents, aswas recognised by the Court of Appeal inits judgment.

Arrangers have also been exploringalternative solutions to remove the needfor the flip provision. These range fromthe dramatic, such as removing the swaptransaction entirely and addressing thecashflow risk through increasedenhancement, to the innovative, such asmaking use of options and morestructured swaps. The permanentsubordination of swap terminationpayments has also been considered bytransaction parties. Nevertheless, allthese options have pricing consequencesand are therefore imperfect solutions toobstacles created by the over-reaction ofthe rating agencies.

One important distinction to make isthat whether a structural change isnecessary, and the extent of the changerequired, will be dependent on theratings that the transaction is seeking toachieve for the most senior tranche of

notes. The discussion above has beenbased on the assumption that theparties will be seeking a AAA/Aaa/AAArating for the most senior tranche ofnotes. However, for transactions wherethe notes attract a lower rating (such asissuances in relation to regulated utilities

or infrastructure projects) there is scopeto argue that no structural changes arenecessary as long as the swapcounterparty has a rating equal to orhigher than the ratings of the mostsenior class of notes.

ConclusionThe market recovery is fragile and, with the regulatory landscape continually evolving,transactions are under an immense amount of pricing pressure. Many transactionsthat were economically viable before the crisis are no longer so. Additionally, and asdiscussed in our previous article, central counterparty clearing is an inevitability whichwill result in pressure to simplify swap transactions. Against this backdrop it is to behoped that the rating agencies will take the view that, for swaps with replacementtriggers, no restructuring is necessary and the flip provision can continue to be used.

It is widely hoped that the Supreme Court will uphold the Court of Appeal judgmenton the basis that secured waterfalls fall outside the anti-deprivation principle,following Patten LJ’s judgment in the Court of Appeal. This would eliminate the needfor additional risk factors, additional legal opinion analysis and would be welcomed bymarket participants. However, quite how the conflicting decisions of the US and theEnglish courts will be resolved remains unclear and if Lehman entities successfullyacquire affected notes pursuant to the order on 22 April 2010 discussed above,clarity may never be forthcoming.

New Horizons 68


12. Launch of the first Frenchsecuritisation company

There are significant advantages to theuse of this new form of vehicle and weanticipate that such French securitisationcompanies will be used frequently forFrench and pan-European securitisationand structured finance transactions.

A key feature of these companies is thatthey have express immunity from beingsubject to insolvency proceedings inFrance and are therefore bankruptcyremote by law. This differs from theposition in other jurisdictions where“bankruptcy remoteness” is achieved bya combination of structural andcontractual features (limitation onnumber of creditors, limited recoursenature of payment obligations and non-petition covenants) which may be

supplemented by protection fromcertain insolvency procedures (e.g. thecapital markets exemption whichprotects certain UK special purposecompanies from being put intoadministration in certain circumstances).However, the French Monetary andFinancial Code provides thesecuritisation company with an expressstatutory immunity from any Frenchcorporate insolvency proceeding. Thiscreates a new bench-mark for thebankruptcy remoteness of structuredfinance vehicles.

The securitisation company hascorporate personality, is subject toFrench corporation tax on its incomeand is therefore eligible to benefit from

the network of double tax treatiesnegotiated between France and a widerange of other jurisdictions. This is asignificant advantage compared with theFrench fonds communs de titrisationwhich – due to its lack of legalpersonality and its consequentexemption from corporation tax – oftenhad difficulties in qualifying for doubletax treaty protection. This hindered theuse of fonds communs de titrisation asa central issuer for the securitisation ofpan-European or global receivablesportfolios where the underlyingreceivables are interest-bearing (e.g.multi-jurisdictional loan portfolios).

The use of a French company alsopotentially permits access to the

An interesting recent development in the French securitisation market has been thelaunch of the first domestic French securitisation company, Managed and EnhancedTap (Magenta) Funding SAT, sponsored by Natixis in March 2010. This is the firstexample of such a company being incorporated and issuing billets de trésorerie –notwithstanding the fact that it has been possible to create such a company since thecoming into force of the ordinance of 13 June 2008. Magenta Funding will act as anABCP conduit vehicle for the securitisation of receivables including trade receivablesor loans originated in France or elsewhere in Europe.

New Horizons 70

Originators

Counterparties or Commercial Paper

�Securitisation Company

Compartment A

Authorised Management Company

Sale ofReceivales

Credit Enhancement/Hedging

Purchase of Notes or units

Custodian�(Credit Institution)

Compartment B

SecuritisationVehicles

Investors

Billets de trésorerie


A new ABCP programme structure


71 New Horizons

European Central Bank liquidity andrepo facilities which are not available tonon-EU issuers – such as ABCPvehicles incorporated in Jersey.

The securitisation company can createcompartments – these can bestructured to be legally separate so thatunless the documentation providesotherwise, the assets of thecompartment are available only to meetthe liabilities of such compartment. Thisgives structural flexibility and an abilityto amortise the start-up costs by usingthe vehicle for a series of distinctsecuritisation or repackagingtransactions. The structural flexibilitypermits certain transaction specificarrangements to be compartmentspecific such as transaction-specificcredit enhancement or-hedging

arrangements which relate, and haverecourse, only to the assets of thatparticular compartment, whilst otherarrangements may be at company level.

Securitisation companies must bemanaged by a management companywhich is authorised by the FrenchAutorité des Marches Financiers. Thisgives comfort to investors that themanager is a French regulated entityand provides a structural barrier to thecompany attempting to de-localise itscentre of main interests with a view topetitioning for insolvency in a jurisdictionother than France.

Whilst being well adapted to being usedas an ABCP conduit vehicle or for thesecuritisation of French and Europeanreceivables, the companies can also be

used for synthetic securitisations and tosecuritise certain forms of re-insurancerisk. However, for the moment they cannot be used to hold and directlysecuritise physical assets such as realestate or aircraft (except followingenforcement of a security interest).Accordingly, their statutory bankruptcy-remoteness is not yet a completeanswer to the issues raised in the CoeurDefense context which is exploredelsewhere in this publication.

New Horizons 72


13. RMBS revisited

European regulatory bodies and marketparticipants have been working together,along with other interested stakeholders,on the implementation of sound andconsistent disclosure requirements. Aparticular driver is the changes which willbe required when a round ofamendments to the Capital RequirementsDirective (“CRD”) are implemented at theend of this year for commencement in2011. Of particular significance in thisregard is new Article 122a of the CRD,which will require increased due diligenceby investors of not only underlying assets,but also transaction structures and cashflows. In addition, the recent Bank ofEngland consultation paper seeking viewson proposals for its liquidity facilities (thatis, the discount window facility) for thebanking system has explicitly placedfurther emphasis on the desirability forenhanced disclosure and standardisationin the securitisation industry. Theproposed revisions, which the Bank ofEngland states would be adopted during2011, would require counterparties tomake publicly available granularinformation in the form of loan-level datafor most asset backed securities andstandardised summary tables in investorreports, as well as standardisation of keylegal documents, summaries of structuralfeatures and cash flow models for eachtransaction. see also “Investor Disclosure”on page 1.

The shape of the UK RMBSmarket

The UK RMBS market is dominated bymaster trust issuance. Improvingtransparency and disclosure in relationto master trusts may well be tricky, asmaster trusts are typically highlystructured transactions adorned with“bells and whistles” features which aredesigned to offer funding flexibility tothe issuer/originator and are tailored toaccommodate portfolios comprised of

various different types of mortgageproduct. Master trust issuers typicallyhave US issuance capability and hencehave been required to provide loanstratification tables to investors.However, they have not historically beenrequired to provide loan-level data.Providing such data would not bestraightforward due to the large amountof data involved and the revolvingnature of the master trust portfolios,which, in some cases, include hundredsof thousands of loans. Complying withrequirements to provide more granularinformation and cash flow models in theform currently envisaged by the newregulations and industry proposals istherefore going to be particularlyproblematic for this type of transaction.In addition, the frequency of reportingproposed by the Bank of England in itsconsultation paper (i.e. the productionof loan-level data on each bondpayment date; and for revolving pool ofassets, each time a new pool isadded) will present particular costand administrative challenges formaster trusts.

In light of these challenges, we believethat there will be a shift towards simplerand more standardised residentialmortgage securitisations in the form ofstand-alone transactions. In our view, itis likely that, in the short to mediumterm, there will be an increase inissuance of stand-alone securitisations,with a good chance of stand-alonetransactions gaining increasingprominence in the market over time.There are several reasons for this: firstly,the residential mortgage products being

offered by lenders have become simplerin recent times, so there will be lessneed for the flexible features and addedcomplexity of the master trustprogrammes, and, therefore, a movetowards less opaque and morestandardised structures; secondly, it islikely to be easier for both originatorsand investors to comply with newregulatory disclosure requirements,including the provision of cash flowmodels and loan level data, for stand-alone issues with discrete pool of loansthan it will for master trusts; thirdly, itmay well be that certain investors wantexposure to a specific vintage of loan orproduct type, rather than to anoriginator’s entire mortgage business;and, fourthly, investors may wantgreater ability to control, and potentiallysell, a securitised portfolio in adefault/enforcement scenario,particularly when the originator isinsolvent. Although we do envisage atrend towards simpler, stand-aloneRMBS transactions in the future, publicRMBS issuances off master trusts overthe past six months have shown thatthis product is still well received byinvestors and we believe that institutionswill continue to use master trustprogrammes as a funding source goingforward, not least because they requirea number of periodic transactions towork efficiently and are attractive toinvestors who want exposure to thebusiness of the originator rather than aspecific vintage or portfolio.Consequently, we envisage in the short-to-medium term the development ofparallel RMBS markets: master trustissuance and stand-alone issuance.

In this article, we observe how initiatives to promote transparency and disclosure in thestructured debt market in the wake of the global economic crisis could shape theresidential mortgage backed securitisation (“RMBS”) market going forward.

New Horizons 74

“We believe that there will be a shift towards simpler andmore standardised residential mortgage securitisationsin the form of stand-alone transactions”


Stand-alone RMBSstructures

There are broadly three ways ofstructuring stand-alone RMBStransactions: the “additional class ofnotes” structure, the “modified mastertrust” structure and the “contractualseller/investor interest” structure, each ofwhich has been used on securitisationtransactions in the market.

The additional class of note structureuses additional classes of notes toprovide credit enhancement for thetransaction. The additional notes can bestructured as fully paid up term notes or,if more flexibility is required (because, forexample, the amount of enhancementwould fluctuate during the life of thetransaction) can be structured as VariableFunding Notes or as Partly Paid Notes.The advantage of structuring theenhancement as a note instrument is thatit is a more marketable instrument than aseller interest and all cash flows from theportfolio can be applied down the issuerwaterfall, which may simplify calculationsand cash management.

Alternatively, a modified version of amaster trust can be used. This structureuses a single tier, rather than a doubletier, trust structure, whereby a specialpurpose company appointed asmortgage trustee holds the portfolio ontrust for the seller and the issuer, andinterest and principal payments on thetrust property and losses thereon areallocated to the seller and the issueraccording to a seller share and an issuershare, respectively. This is a one-offtransaction structure, however, and doesnot allow for multiple transactionssecured against the same revolvingmortgage portfolio. Notwithstanding this,the mechanics of this structure operate ina similar (but simpler) way to master trust

structures, with the seller share of thetrust providing support for potential set-off losses and a mechanism for the sellerto pay funds into the transaction to fundcash borrow backs under flexiblemortgage loans.

The third potential structure is thecontractual seller/investor intereststructure, which operates in a similar wayto the modified master trust structure fora single transaction, but rather thancreating a trust, the mortgage loans aretransferred by the seller directly to aspecial purpose vehicle issuer and aseller interest and investor interest in therevenue and principal receipts of themortgage loans held by the issuer arecreated by virtue of a contractualarrangement and payments are madeback to the seller by way of deferredconsideration. This structure is, in ourview, a simpler way of achieving thedesired result than using the modifiedtrust structure and also avoids thecomplicated bare trust tax analysis of themodified trust structure.

In addition to the simplification oftransaction structures described above,other aspects of RMBS are likely to besimplified going forward. For example,swap structures may change as a resultof rating criteria becoming more difficultto satisfy and there being less entitiesprepared to act as third party swapproviders. This could result in a movetowards simplicity, by moving away fromswaps which are tied to the income

generated on the portfolio towards moregeneric swaps which should be easier tovalue and replace. For example, ratherthan swapping a blended portfolio ratefor LIBOR, swapping the Bank ofEngland base rate for LIBOR andsupporting this with additional creditenhancement, and making interest onjunior classes of notes more “passthrough” for notes which are beingretained by the originator, based on theunderlying mortgage rates rather thanLIBOR. In addition, there is also scope forsimplification in other areas, for example,by making payment waterfalls morestraightforward.

Standardisation

One of the concerns raised by the Bankof England in its consultation paper, isthe lack of standardisation ofsecuritisation documentation. Inparticular, the Bank of England observedthat there is no standardisation ofoffering documents, so each transactionrequires individual, detailed analysis toidentify the associated legal andstructural risks, with it being difficult toextract even the most basic information,such as cash flow triggers and votingrights. Various industry initiatives areexploring the standardisation ofsecuritisation documentation. Forexample, there is an ICMA discussionforum for market participants which isconsidering, amongst other things, thepotential to standardise securitisationdocumentation. In addition, the


75 New Horizons

“The Bank of England observed that there is nostandardisation of offering documents, so eachtransaction requires individual, detailed analysis to identifythe associated legal and structural risks, with it beingdifficult to extract even the most basic information”

New Horizons 76

AFME/ESF has been actively engagedwith members in an effort to standardiseinvestor reports, definitions anddocumentation for stand-alone RMBS,which would serve as the starting pointfor documenting an RMBS transaction.This workstream is particularly useful asit is a forum for bringing together allaspects of the market, and includesrepresentatives from issuers, investors,credit rating agencies and law firms,including Clifford Chance. The Bank ofEngland, FSA and UK Treasury are alsoobservers on these initiatives.

One of the AFME/ESF working groups inwhich we are participating is working ona standard form RMBS prospectus,including a standard form summarysection and standard forms of disclosurefor, for example, representations andwarranties of the originator. Theintroduction of a standardised summarysection of the prospectus which sets outthe pertinent features of the transactionand cross refers to relevant sections ofthe prospectus for further detail will behelpful for investors and go some waytowards addressing the Bank ofEngland’s concerns mentioned above. Inaddition, standardised definitions, anotherAFME/ESF working group, if successful,would help to eliminate confusion, forexample, in investor reports, wheresimilarly named fields have differentmeanings depending on the party issuingthe report. Whilst a certain level ofstandardisation in the market may beachievable and the transactiondocumentation could usefully includestandard key terms and certain standarddefinitions, in our view, it is unlikely thatstandardisation would be taken as far as,for example, creating a complete set ofISDA style standardised RMBSdocuments. Providing for the broad rangeof deviations which would be requiredfrom the standard documents, for

example, because of the differentmortgage products and originationpractices, would not be practical andcould well cause greater confusion forinvestors and more opaquedocumentation. The most importantfactor is that disclosure addstransparency and highlights differencesfrom standard approaches and we do notbelieve that being overly prescriptive willachieve that purpose.

It is also worth noting that some marketparticipants are supportive ofstandardisation in general, but othersconsider there to be a danger that, byproducing standardised documents, anytransaction which does not sit squarelywithin the standardised documentation isregarded as “off-market”, with potentiallypricing and other implications. In a similarvein there are concerns, particularlyamong UK RMBS issuers, that proposalssuch as the prime collateralised securitiesinitiative, which aim to attach animprimatur to certain transactions, willcreate a two tier market.

Transparency of offering documents canalso be improved by including riskfactors which are clear and concise andproportionate to the risk beingdescribed. Over the years, risk factors inprospectuses have tended to becomelong and rambling, with much repetitionand disproportionate disclosure beinggiven to certain deminimis risks, withsome risk factors automatically beingincluded as a matter of market practicerather than being evaluated on atransaction by transaction basis. Webelieve that, in the sprit of increasedtransparency, a more streamlinedapproach to risk factors should beadopted by the industry going forward.For example, there is a considerableamount of disclosure in relation toregulatory risk factors in RMBStransactions, and sometimes the

identification of the actual risk is lost inthe detailed disclosure which can run toseveral pages of text; furthermore, someof the regulatory disclosure will becomeincreasingly irrelevant going forward asnewer vintages of loans are beingincluded in portfolios (for example, riskfactors relating to the Consumer CreditAct) and the need for inclusion, and thelevel of disclosure, should be re-evaluated for each transaction on a caseby case basis.


ConclusionThe move towards enhancedtransparency and disclosure is apositive one for the industry andshould increase investor confidence inthe RMBS market; however,notwithstanding the fact that, of all themarkets in asset-backed securities, theRMBS market is probably the mostsuited to a standardised initiative, thereare, nonetheless, likely to be somesignificant practical challenges inimplementing standardisation andother industry proposals aroundtransparency and disclosure.

14. Regulated utilities still have theX factor

Over the last ten years, many sponsors inthe UK regulated infrastructure sectorhave looked to the structured wholebusiness securitisation model as a keyfinancing tool for refinancing historicacquisition debt and funding thechallenging capital expenditure targetsset for them by their regulators. Some ofthe large UK water and seweragecompanies led the way but the modelhas since been adopted to some or agreater extent in the UK gas andelectricity sectors. We have alsowitnessed other but less regulatedcompanies such as BAA’s Londonairports come to market with large debtissuance programmes which leverage offmuch of the legal and credit structuresadopted by their pioneering cousins inthe UK water sector.

So what has been the great attraction forsponsors and investors of companiesthat have generally been unloved andoverlooked by the equity markets?Answer: Regulation, Regulation andRegulation! In short, the greater theeconomic regulation and the certainty ofthe economic contract between the utilityand its regulator, the more predictablethe revenue streams become forsponsors and investors. Regulatedutilities benefit from high barriers to entryand the lack of threat of meaningfulcompetition for their consumer base,charges are set on a five yearly basisunder well established price controls(commonly referred to as “RPI – X”) andinvestment is rewarded through a return

Despite the downturn in the markets over the last few years and the scarcity of newmoney investors in structured debt products, structured utility bonds issued in theregulated infrastructure sector have survived relatively unscathed and, over the last 12months, have emerged from the credit crisis with renewed vigour attracting a significanttightening in spreads reflecting the increase in demand for long dated investment gradepaper from fixed income investors (particularly looking to match inflation linked liabilitiesor looking for some extra yield pick-up from Class B bond issuance). A successfuldistribution of large amounts of “A” and “BBB” category paper has been achieveddespite the absence of the monolines and a “AAA” credit wrap, whose participationwas so instrumental in helping to develop the market for structured utility bonds.

New Horizons 78

Recent regulated infrastructure issuance includes:

June 2009Anglian Water Services Financing plc - issuance under its existing whole businesssecured financing programme of £100,000,000 Class B 6.755 per cent. Fixed toFloating Bonds due 2024

July 2009Yorkshire Water Services Bradford Finance Limited - establishment of a wholebusiness secured financing programme and initial issuance of £275,000,000 Class A6.00 per cent. Fixed Rate Bonds due 2019, £200,000,000 Class A 6.375 per cent.Fixed Rate Bonds due 2039 and £175,000,000 Class A 2.718 per cent. IndexLinked Bonds due 2039

December 2009BAA Funding Limited - issuance under its existing whole business secured financingprogramme of £700,000,000 Class A 6.75 per cent. Fixed Rate Bonds due 2028and £235,000,000 Class A Index Linked Bonds due 2041

February 2010South East Water (Finance) Limited - issuance under its existing whole businesssecured financing programme of £130,000,000 2.5329 per cent. Senior IndexLinked Bonds due 3 June 2041

March 2010Wales & West Utilities Finance plc - establishment of a whole business securedfinancing programme and initial issuance of £100,000,000 Class A 2.496 per cent.Index Linked Bonds due 2035, £300,000,000 5.75 per cent. Class A Fixed RateBonds due 2030 and £115,000,000 Class B Fixed to Floating Rate Bonds due 2036

Dwr Cymru (Financing) Limited (Welsh Water) - issuance under its existing wholebusiness secured financing programme of £140,000,000 1.859% Class B IndexLinked Bonds due March 2048

April 2010Yorkshire Water Services Bradford Finance Limited - further issuance under itsexisting whole business secured financing programme of £100,000,000 6.375 percent. Fixed Rate Class A Bonds due 2039, £85,000,000 2.718 per cent. Class AIndex Linked Bonds due 2039 and £450,000,000 6.00 per cent. Class B Fixed toFloating Rate Bonds due 2025

May 2010Anglian Water Services Financing plc - issuance under its existing whole businesssecured financing programme of £130,000,000 2.262 per cent. Class A IndexLinked Bonds due 2045]


on a regulated asset base which growsthrough capital investment andindexation. Furthermore, a combinationof special insolvency regimes andregulatory ring-fencing add a degree ofinsolvency remoteness that would notapply to a typical UK corporate. All ofthese factors are a credit positive forstructured debt issuance.

As we approach 10 years of structuredutility bonds and the 20th anniversary ofRPI-X, we take a look in this article atrecent trends in the market andeconomic regulation. Whilst there havebeen challenges in successfullyexecuting large structured utilityrefinancings (some of which we describein more detail below), the legal and creditstructures of the original groundbreakingtransactions in the UK water sector haveproven to be remarkably robust.Furthermore, whilst for reasons set outfurther in this article, it may prove moredifficult for sponsors to find thenecessary efficiencies to outperform theregulatory settlement, the shift ineconomic regulation is not expected tobe so fundamental to causeinfrastructure funds and investors to exitthe market or end the bidding for utilitycompanies in the M&A markets.

The X-factor - somethoughts on the futureapproach to price controlsfor UK network utilities

Introduction

Regulators across the UK’s utilitynetworks are facing a common problem.The price control regimes for the energyand water sectors put in place atprivatisation are no longer delivering theeasy wins that were once available; theimperatives of external factors such asclimate change and shifts in the pattern

of consumption or supply mean that theprice control regime is being directedtowards an increasingly complex anddiverse set of objectives; whilst at thesame time both the water regulator(Ofwat) and the energy regulator (Ofgem)have been under considerable politicalpressure to keep prices down.

Investors and lenders have becomefamiliar with the current regime of fiveyearly price reviews based on an RPI-Xformula designed to squeeze outefficiencies and embraced (or at leastaccepted) by the regulated as anopportunity to outperform expectationsand keep a share of the benefits. Thismodel places great emphasis on acompany’s Regulated Capital Value orRCV (the nominal value of its regulatedasset base) and the weighted averagecost of capital or WACC (the allowedreturn on a regulated company’s RCV)Over the next few years, a combination ofthe factors referred to above will lead tofundamental changes in the way in whichthe price control regimes in these twosectors operate.

Portents

There are already some signs of whatprice control settlements in the energyand water sectors will look like in thefuture. In November 2009, Ofwatpublished its final determination for theperiod 2010-2015 (PR09). This wasrejected by one company – Bristol Water– whose determination is currently beingreviewed by the CompetitionCommission. In December 2009, Ofgempublished its final proposals for the

electricity distribution price control review2010-2015 (DPCR5) – which wasaccepted by all 14 distribution networkoperators (DNOs). Both of these pricecontrol settlements were introduced at atime of considerable uncertainty in thefinancial markets (making it difficult toprice the cost of capital) and both containnew features which point to what futureprice controls will look like.

In addition to Ofwat’s PR09 and Ofgem’sDPCR5 price settlements, bothregulators have publicly signalled theirintention to review the way in whichprice controls are implemented. InMarch 2008, Ofgem launched the RPI-X@20 review to examine the currentapproach to price setting and to developOfgem’s future strategy – Ofgem’semerging thinking on the RPI-X@20review was published in January 2010and the final conclusions are expected inthe summer of 2010. Similarly, in April2010, Ofwat published its “Water Today,Water Tomorrow” strategy document inwhich it declared its intention to roll outa “future regulation” programme. Ofwathas also set up an advisory panel tohelp develop its future strategy across arange of issues, including the form offuture price controls. This programmewill incorporate the recommendationsmade by the Walker Review intohousehold charging, published inDecember 2009. Also in the mix is therecent announcement by the Office ofFair Trading (OFT) that it will undertake a“stock-take” of UK infrastructure, lookingat how ownership and gearing affectsoutcomes for consumers.


79 New Horizons

“So what has been the great attraction for sponsors andinvestors of companies that have generally been unlovedand overlooked by the equity markets? Answer:Regulation, Regulation and Regulation!”

New Horizons 80

Recent structuraldevelopmentsInflation Linked Hedging

Many sponsors, at the time of acquiring aregulated utility, have bought long datedinflation linked hedges as a means ofinitially hedging their floating rate bankexposure but also with a view to lockingin spreads on subsequent inflation linkedcapital markets issues. Inflation linkedswaps due to their accreting natureprovide lower levels of gearing at theoutset but also increasing volatility withrespect to their mark to market. However,as the credit markets turned, issuersstruggled to find capacity for index linkedbond issuance-leaving sponsors with thechoice of raising additional debt toterminate existing inflation linked hedgingor to restructure all or some of theirinflation linked hedges. However, whilstthe swaps are often long dated to createsynthetically the profile of a long datedinflation linked bond, inflation swapproviders have required optional ormandatory breaks resulting in the riskthat an Issuer will be exposed to amaterial termination payment which it willneed to fund within its covenants by theraising of new debt. These early breakprovisions do not sit well with thecustomarily limited termination rightsafforded to hedge counterparties instructured debt transactions.Furthermore, whilst historically refinancingrisk has been addressed through maturitycovenants limiting by a percentage ofRAV the amount of debt falling due forrepayment within 2 years and the periodof the price control, the precedenttransactions do not factor in theaccreting notional amount of thesehedges and the volatility of their mark.

Thus sponsors have had to adapt to therequirements of the rating agencies andinvestors by acceding to more complexhedging policy covenants to minimiserefinancing risk but also to ensure amigration over time to a more predictable

and stable inflation linked profile. Thesecovenants have included lower levels ofgearing whilst non-compliant inflationswaps remain in place, dividend lock-upsand additional indebtedness tests beingset at lower gearing levels and excludingthe benefits of non-compliant inflationswaps when calculating certain post-maintenance interest cover financial ratios.It follows also that the accreting notionalamount that has a break within the two orfive year testing period will count towardsdebt falling due for refinancing within theapplicable maturity covenants. Therefore,the financial indebtedness maturitycovenant which has long been a feature ofthese types of transactions and aims torestrict the amount of financialindebtedness falling due in any 2 or 5 yearperiod and therefore maintain a healthydebt profile, has been adapted in recenttransactions to take account of accretionon index linked swaps with an early orscheduled maturity date within the same 2or 5 year period. Finally, regardless ofwhether the swaps are compliant for earlybreak purposes, the super-senior nature ofinflation linked hedging relative to bonds inthe transaction waterfalls has resulted in alimitation on the aggregate accretingprincipal relative to debt if the sponsorswish to avoid the occurrence of a triggerevent and a mandatory cash lock-up.

Dry Securitisations, Flipper Bonds andPartial Refinancings

Whilst historically the debt markets mayhave been deep enough to accommodatea “one shot” refinancing of acquisitionbank debt incurred by sponsors inacquiring a utility business, this has provedparticularly challenging for utilities acquiredprior to the credit crunch but with soft orhard refinancing commitments on theirbank debt. As a result sponsors havelooked at other options ranging frompartial refinancings through so called“flipper” bond issuance to a full refinancingby way of medium term bank debt undera 100 per cent. or substantially bankfunded structured debt programme (a so

called “dry securitisation”), tranched toreflect Class A and B funding and withmaturities that allow an orderly refinancingover time in the capital markets. Inaddition, owners who might be looking tosell have used flipper bonds (so calledbecause they can be “flipped” into asecuritisation programme (with all that thatentails such as detailed covenant changesand intercreditor arrangements) withoutnoteholder consent as means of meetingcurrent funding requirements but withoutnecessitating an expensive liabilitymanagement exercise for any prospectivepurchaser that would look to thestructured debt markets as means ofrefinancing its acquisition were it to besuccessful. Flipper Bonds have beensuccessfully (and efficiently) migrated tothe whole business securitisations ofThames Water, Yorkshire Water and Wales& West Utilities Limited.

Stranding options for Legacy Bonds

Many utilities that have been acquiredhave had outstanding a series of plainvanilla bond issues, in many caseswithout significant covenant protection forbondholders. Often these bondholdershave no particular interest in migratinginto a securitisation and would rather beredeemed with their full spens make-whole. Thus sponsors and arrangershave had to look at other alternatives tosecure the participation of these legacybond investors. In several cases theweakness of the covenants in the legacybonds have allowed sponsors as a lastresort to proceed with establishingstructured utility bond programmes andissuing off that platform regardless ofwhether the legacy bond investorsconsented to migrating the securitisedterms. By exposing the investors to therisk of being stranded without many ofthe direct benefits provided to thesecuritised investors, it is often the casethat all or a majority of the legacybondholders will agree to migrate into thesecuritisation for an all in cost which islower than their spens entitlement.


81 New Horizons


From these various initiatives can bedrawn a number of common themeswhich give some shape to the futureregulation of the energy and watersectors. These themes can be broadlydescribed as follows - first, a much finercalibration of the rewards and penaltymechanisms embedded within the pricecontrol mechanism; secondly, re-assessing financeability and putting lessemphasis on WACC; thirdly, a greaterfocus on outputs (as opposed to costs)and greater stakeholder engagement;fourthly, a longer term approach to thesetting of incentive mechanisms.

Taking each of these in turn:

Calibration

In PR09, Ofwat introduced the CapitalExpenditure Incentive Scheme (CIS)which is intended to incentivisecompanies to put forward challengingbusiness plans prior to the pricesettlement and then to outperform thetargets set by Ofwat. Companies arerewarded or penalised depending on howclosely actual expenditure compares toforecast expenditure. The CIS mechanismis similar to Ofgem’s Information QualityIncentive (IQI) which it introduced inDPCR4 and carried through to DPCR5.

In addition to the IQI mechanism, Ofgemalso introduced a wide array of additionalincentives or obligations in DPCR5 toencourage DNOs to behave in aparticular way. These cover environmentalincentives such as the inclusion of a £500million low carbon network fund to enableDNOs to trial new technology; customerservice incentives which reward orpenalise DNOs according to measuredlevels of customer satisfaction; andnetwork incentives to encourage DNOsto invest efficiently. As part of itsapproach to networks, Ofgem equalisedincentives across all network expenditure,capitalising 85% of all network operating

or investment costs (other thanmanagement costs and overheads) anddepreciating them over a 20 year period.This was aimed at ensuring that, whenchoosing between replacing or repairingcapital assets, DNOs’ incentives were notbeing skewed by the different regulatorytreatment of opex (fast money –recovered in the year of expenditure) andcapex (slow money – added to RCV andrecovered over time). This approach wasendorsed in Ofgem’s emerging thinkingon RPI-X@20.

The cumulative effect of these variousmechanisms will be to disaggregate thepotential upsides or downsides of a pricecontrol settlement. This will makedetermining whether or not a givensettlement will provide a solid financialbasis for the lifetime of the price controlperiod a real challenge – particularly forthose one step removed from the pricereview process.

Financeability: a move away from anindustry-wide WACC

Both Ofwat and Ofgem have a statutoryduty to ensure that licensed companiesare able to finance the carrying out oftheir regulated activities. Under thecurrent RPI-X model, this has beenachieved by including within the level ofrevenue that a regulated company isallowed to recover, an allowed return onthe RCV – the WACC. Despite the recentturmoil in financial markets, both recentprice settlements have adoptedchallengingly low WACCs – in PR09,

Ofwat applied a post tax WACC of 4.5%;for DPCR5, Ofgem adopted a WACC ofonly 4%. There are two identifiable trendsat play in arriving at this level of WACC.

First, both Ofwat and Ofgem appear tobe stretching the concept offinanceability. The key financial ratiosemployed by Ofwat for PR09 were cashinterest cover; adjusted cash interestcover; funds from operations:debt;retained cashflow:debt; and gearing. Fora company to be considered financeableOfwat targeted financial ratios consistentwith an A-/A3 credit rating. In PR09,Ofwat recognised that three companies(Bristol, South East and Thames) wouldnot meet this financeability test as a resultof significant growth in their RCV. Foreach of the three companies, Ofwatassumed shareholders would inject moreequity in order to allow the regulatedbusiness to finance its functions. Thisimplies that Ofwat interprets its duty toensure that water companies can financetheir activities in a way that does notrequire Ofwat to set the WACC at a levelthat will ensure a well-managed companyis consistently able to maintain the targetfinancial ratios. This point is currentlyunder appeal in the CompetitionCommission, where Bristol Water areunsurprisingly making the point that ifOfwat can reach the view that a companyis financeable, even where its targetfinancial ratios are not met, on the basisof an assumed equity injection, then thisundermines the notion of financeability.Put simply, once you allow Ofwat to

“Regulators across the UK’s utility networks are facing acommon problem. The price control regimes for theenergy and water sectors put in place at privatisationare no longer delivering the easy wins that were onceavailable”

New Horizons 82


assume an injection of equity, there willnever be a situation where a companydoes not have access to finance. Thisstrips any meaning from the dutyimposed on Ofwat to ensure that allregulated water companies are able tofinance their functions. However, Ofgemproposes to follow a similar approach toOfwat. In its emerging thinking on theRPI-X@20, Ofgem set out “straw man”principles on financeability whichacknowledge that, provided allowedrevenues cover financing costs onaverage over time, the fact that they maynot do so at any particular point in timewould not be sufficient reason to adjustthe level of allowed revenues (or theWACC). As a consequence, Ofgem hasalso signalled that it would considermoving away from using the samefinancial ratios as the rating agencieswhen assessing financeability – inparticular by placing less or no emphasison short term cash flow ratios.

Secondly, the increasing complexity ofthe incentive schemes has meant thatalthough the headline level of return onRCV may be quite low, there is scope foradditional upside in capturing individualincentive payments. In DPCR5, Ofgemformalised this by adopting a measure itcalled return on regulated equity (RORE).Ofgem’s RORE analysis involved itlooking at DNO performance againstOfgem’s assumed level of costs; theassumed cost of debt and level ofgearing and, importantly, the scope forDNOs to earn additional revenuesthrough the various incentive schemes.For DPCR5, Ofgem estimated that aplausible upside return would be between10% and 13% - considerably in excess ofthe headline post tax WACC figure of 4%(4.7% pre-tax). By holding the WACCdown and shifting anticipated returnsonto the incentive mechanisms, Ofgem iseffectively making the DNOs run to stand

still – those DNOs who stumble and donot outperform will suffer a decrease intheir overall rate of return; a decreasefrom an already low base.

Another development heralded inOfgem’s RPI-X@20 review is the prospectof a “variable WACC” – in other words,rather than a single WACC being appliedacross an industry, individual regulatedcompanies would be rewarded with animproved WACC where they haveestablished a track record of planningand delivering efficiently.

All of these developments will serve toundermine the role of the WACC in futureprice settlements.

Output-driven regulation andenhanced stakeholder engagement

A key theme of Ofgem’s RPI-X@20 reviewis that future price reviews should focuson outputs rather than inputs. Outputsshould deliver both a sustainable energynetwork and secure value for money andOfgem anticipates a number of outputcategories comprising reliability, safety,environmental targets, conditions forconnecting to network services andcustomer satisfaction. Despite this changeof focus, there is no suggestion thatOfgem intends to adopt a laxer approachto costs. Indeed, one proposal being putforward by Ofgem is to introducecompetition into the delivery of outputs inorder to lower the cost of delivery – whichcould involve regulated companiestransferring ownership in assets to third

parties or even having their licencerevoked for persistent non-delivery.

As part of an output driven process,Ofgem anticipates that future pricereviews will involve regulated companiesproposing their own targets, taking intoaccount legal requirements and inputfrom stakeholders such as customergroups. These proposed targets wouldthen be assessed by Ofgem (whichwould have conducted its ownstakeholder research) before the finalprice settlement was reached. Regulatedcompanies would be rewarded accordingto how well they achieved the definedoutputs – this would involve assessmentagainst qualitative criteria such ascustomer satisfaction. Differentcompanies would be subject to differinglevels of scrutiny.

One specific proposal which hasattracted a lot of comment is Ofgem’ssuggestion that in order to increasestakeholder engagement in the pricesetting process, third parties should havethe right to challenge the final pricesettlement (currently only regulatedcompanies can do this). This proposalhas the support of large customers suchas Centrica, but other observers haveclaimed it would introduce considerableuncertainty and delay into the processand shift the main focus of the pricesetting process to the appeal stage in theCompetition Commission.

“These developments will significantly increase thecomplexity of the price review process and introduce agreater degree of subjectivity both in the targets set andthe level of performance achieved (which in turn will impactthe level of return received by regulated companies)”

83 New Horizons


Although it has not echoed Ofgem’sproposal of a third party right of appeal,Ofwat has also taken steps to focus on amore outcome-led and stakeholder-drivenapproach. In the recent PR09 pricesettlement, Ofwat introduced the ServiceIncentive Mechanism (SIM) which willreplace the overall performanceassessment (OPA) used to date. The keydifference between the two mechanismsis that whereas OPA measuredperformance against a range of fixedindicators (for example speed ofresponding to calls), SIM attempts tomeasure the overall customer experienceand so is more qualitative. As for OPA,SIM will rely on both a reputationalincentive (Ofwat published league tables)and a financial incentive – ranging from+0.5% to -1%.

These developments will significantlyincrease the complexity of the pricereview process and introduce a greaterdegree of subjectivity both in the targetsset and the level of performance achieved(which in turn will impact the level ofreturn received by regulated companies).

Longer term price controls

Currently, both Ofgem and Ofwat setprices on a five yearly basis - althoughOfwat requires companies to publish astrategic direction statement setting outthe long term strategy of the business.Both Ofgem and Ofwat have indicatedthat they will consider whether to move

to a longer price control period. Ofwathave yet to publish anything concrete inthis regard, but in May 2010, Ofgempublished a paper setting out its currentthinking on the length of the pricecontrol period.

Ofgem envisages extending the pricecontrol period to between 8 and 10years, with a “mini-review” half waythrough that period to check certainpre-specified aspects (for examplewhether output requirements remainappropriate). Allowed revenue would beadjusted within such period to reflectrewards or penalties accrued and therewould need to be a series of re-openers or adjustment events that

would allow the price control settlementto be revisited part way through theperiod upon the occurrence of certaindefined events – for example a changein the cost of an underlying input or acategory of inputs above or below agiven level.

The impact of a longer price reviewperiod will depend how it is structured –a longer period should in principleincrease certainty, although this will haveto be balanced against the need for mini-reviews mid-term or a more extensive setof re-openers.

ConclusionSo, looking into the future what can we expect?

n More complexity – price control is no longer about squeezing costs out ofinefficiently-run former public utilities, it is about sending increasingly complex pricingsignals to network operators and others in order to incentivise them to directexpenditure in a way which will further broader regulatory objectives; mostparticularly sustainability (which is at the heart of both Ofgem’s and Ofwat’s priorities).

n Less clarity over the ability of a regulated company to keep consistently withinaccepted financial ratios – regulators will tolerate short term cash flow difficultiesand the overall scope for a regulated company to outperform a price settlementwill be more difficult to assess than it is now.

n A more involved process – whether or not third parties are given the right toappeal the final price settlement, their input will become increasingly important indefining the settlement and in determining the level of reward a company willachieve at the end of the price control period.

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15. Restructuring of CMBStransactions in Germany

Common issues on GermanCMBS loansA number of different situations canarise under German transactions,most of which are not unique toGermany and have been encounteredacross European CMBS transactions.The three presently most typicalsituations are the following:

Obligations exceed assets

As in many other jurisdictions, theGerman market has witnessed a trendin which the value of the properties hasdecreased below the value ofoutstanding principal under thefinancing of such loan.

Overdue payment obligations

In many instances borrowers approachlenders and servicers with a request toallow for certain dedicated funds to bereleased and used for the purpose ofpaying outstanding invoices for capitalexpenditures, services related to theproperty or simply taxes.

Obligations exceed assets andshareholder loses interest incontinuation of shareholding

In situations where the equity providerto a borrower, whose outstandingobligations exceed its assets, comes tothe conclusion that its shareholding willnot yield any further returns, it mighttake the view that it would be sensibleto either file for insolvency or transferthe shares in the borrowers to thelender or a person appointed by thelender. This is often combined withvarious threats to file for insolvencyand a request to reduce outstandingcommitments by sponsors tomake payments.

Strategies to restructure aGerman loan secured onGerman real estateThere are various approaches to mostissues and no single approach is likely tobe the only correct approach to a givensituation. Here are a few possible ways ofdealing with any given situation. Theapproach which should be used in agiven scenario will depend on a numberof factors including, without limitation, athorough commercial and legal analysisas well as the factual willingness of allparties to cooperate.

Waiver

A (temporary) waiver may be appropriatein situations where an event of defaultsuch as an LTV breach has occurred, butwhere the borrower continues to meet itspayment obligations and its financialcondition appears otherwise stable, sothat an enforcement does not seem to bea compelling measure at this stage.

Standstill

If an event of default under a loan hasoccurred, the lender may agree not topursue any remedies and, in particular,not to accelerate the loan within anagreed period of time on the basis thatthe borrower otherwise complies withits obligations under the loan. Thisprovides the borrower with “breathingspace” to propose a solution to thelender on how to proceed with respectto a potential restructuring.

Prolongation

Another option to consider in the caseof (anticipated) payment shortfalls of theborrower, in particular due to refinancingdifficulties at maturity, is the prolongationof the loan, thereby speculating on more

favourable market conditions at a laterdate. However, in the case of CMBSloans, there are additional constraints.The notes issued in CMBS transactionswhich are backed by such CMBS loansregularly mature two or three years afterthe loan within a so-called “tail period”which is intended to give sufficient timefor enforcement in the event that theloan defaults. Noteholder consent isregularly required if it is considered toextend the term of the loan until after thematurity date of the notes. Suchnoteholder consent is often difficult toobtain in practice.

Taking over the shares in theborrower or taking over theproperties

As mentioned above, a lender may finditself forced to “take over the keys”. Thismeans a situation in which it is asked bythe sponsor of the borrower(s) to takeover the shares in the borrower(s) or toacquire the properties. This can happen,for example, where the equity provider toa borrower is of the view that itsshareholding will not yield any furtherreturns and that it has no further othercommercial interest in the transaction (forexample, as an asset manager). In suchcase the request to “take over the keys”can be emphasised by a threat to file forinsolvency, in particular where it is likelythat any forced sale of the properties(within or outside of insolvencyproceedings) will lead to a significantdecline in value thereof.

A transfer of the properties to the lenderor a person designated by it would triggerreal estate transfer tax. This may beavoided in a share deal by transferring theshares to two independent transferees, asreal estate transfer tax will only be

In the years up to and including 2008 Germany saw an unprecedented boom inCMBS transactions securitising loans which are secured on German commercialproperties. A number of the loans have experienced difficulties for a number ofreasons. Although the scope of this publication means that this article is not intendedto cover all aspects of this topic, it focuses on some of the key issues surroundingsuch transactions and their restructuring.

New Horizons 86


triggered if 95% or more of the shares in aborrower are (directly or indirectly) unifiedin a single taxpayer after the sale. Afurther point to consider is whether juniorranking encumbrances exist, as these willnot be extinguished upon the taking overof the properties, which can provide forsignificant nuisance value.

Due diligence may be required to assesswhether the borrowers are subject to anyliabilities which are substantial and werenot apparent from the lender reportingobtained under the loan, as such liabilitieswould be taken over in case of a sharetransfer and the equity sponsors will mostlikely not be willing to provide forindemnities in such cases.

Finally, such a transaction will alwaysalso be driven by tax considerations andit is important to analyse this in detailprior to implementation.

Enforcing and insolvency

Where a loan is accelerated followingan event of default, this will most likelylead to an insolvency of the borrowerdue to illiquidity, as it would usually notbe able to refinance the full repaymentamount immediately.

Enforcement of the security over theproperties by way of compulsory auction(Zwangsversteigerung) may beconsidered, however, while no co-operation by the borrowers or itsinsolvency administrator is required, this isusually a lengthy court-controlled processwith only limited influence by the lender.

Another option for the lender in anenforcement scenario is to gain access tothe cash flows generated by theproperties by way of forced administration(Zwangsverwaltung) or, alternatively,enforcement through private “cold”administration by way of agreement withthe insolvency administrator.

In the case of all enforcements it isimportant that the originals of therelevant land charges and securitydocuments are located and can beproduced when required.

Lender liability and delayedapplications to openinsolvency proceedingsTo be determined independentof insolvency regime applicableto borrower

The question of whether a lender wouldbe in danger of being subject to lenderliability if it does not enforce a loan andthereby prolongs the “life/trading” of, ordelays the application for the opening ofinsolvency proceedings regarding thecompany, thereby deepening the damagedone by the ultimately insolvent borrower,is to be answered under German torts law(Deliktsrecht) and not dependent on theinsolvency regime of the borrower. Thegeneral line adopted by the GermanFederal Court (Bundesgerichtshof) is thatthe non-enforcement of a loan (whichwould theoretically be enforceable) wouldin itself not trigger such a liability based oncontravention of public policy. Furtherfacts would need to be present in additionto the absence of enforcement. TheGerman Federal Court stated that suchfacts could, for example, without limitationand much simplified, be present where

(i) economic power or pressure isexercised by the lender vis-à-vis theborrower or another form of influencewas exercised on management for itsown benefit; or

(ii) other creditors of the borrower aremisguided regarding thecreditworthiness of the borrower, forexample, where the lender, e.g. in thecontext of a workout, does not actneutrally but is actively involved inidentifying and persuading third partycreditors to advance new credit orenter into new contracts for thedelivery of goods or services orgrants new credit lines to avert apending insolvency.

How to avoid lender liability

In view of the above, a lender shouldcarefully consider whether a borrowerwho is in financial difficulties will be ableto survive in the medium term and hencewhether prolongation of an existing loanor the advancing of new money is aviable option. In order for the lender todemonstrate that its decisions are basedon a sound footing, it is advisable toobtain a workout opinion(Sanierungsgutachten) which is usuallywritten or verified by independentaccountants. While it is theoreticallypossible to demonstrate the positiveoutlook without a workout opinion, suchopinions have become increasinglycommon in Germany and provide lenderswith the most reliable defence whenfaced with the allegation of lender liability.

In this context, the Institute of PublicAuditors in Germany (Institut derWirtschaftsprüfer, IDW) has published itsstandard IDW S6 “Requirements for thepreparation of a restructuring plan”, whichsets forth a number of requirements to beanalysed in the context of a workout

87 New Horizons

“A lender should carefully consider whether a borrowerwho is in financial difficulties will be able to survive inthe medium term and hence whether prolongation ofan existing loan or the advancing of new money is aviable option”


New Horizons 88

opinion (Sanierungsgutachten) in order toassess whether a restructuring of therelevant company is likely to besuccessful. These include a description ofthe current economic situation, ananalysis of the cause and level of thecrisis and proposed measures to avertthe crisis.

As it requires some time to prepare arestructuring plan and workout opinion onthe feasibility of such plan, a bridge loan(Überbrückungskredit) to a company incrisis will not generally be consideredcontrary to public policy (of course this isa case by case question). Such a loan willnot result in liability of the lender if it ismade in order to prevent illiquidity duringthe period required for the preparationand examination of the restructuring plan.

For the avoidance of doubt, a merestandstill is not technically a prolongation,even if it presents a defence to paymentswhich may otherwise, without thestandstill, fall due. However, it isimportant that a standstill does notfactually result in a prolongation in thedisguise of a standstill because courtsmay then treat it similarly (in which case aworkout opinion is advisable to avoidlender liability).

A further important factor to avoid lenderliability is to ensure that the borrowerretains control of its operations, i.e. thelender should not (either itself or through aperson close to it) take over themanagement of the company or otherwisedeprive the management of its power toact for the company or exert substantialinfluence on its business operations.

“Threats” to file for insolvency

It is not uncommon that demands fromborrowers are combined with a more orless direct hint that the borrower intendsto file for insolvency, unless the demandsare complied with. For the avoidance of

doubt, it is important that any party whichis faced with such a situation does notreact with a request not to file forinsolvency as this can constitute an act ofinstigation to delay the opening ofinsolvency proceedings which is acriminal offence under German law. It is inthe sole discretion of the management ofa German legal entity to file or not to filefor insolvency. What, however, can bedone is to express a view (if it is true) thatone is positive and hopeful about theprogress of the ongoing negotiations (aso called “flower letter”). This can thenfactually help the management of therelevant German borrower to form apositive view about the state ofnegotiations and may support its positivecontinuation prognosis for the duration ofthe negotiations (if appropriate).

Special focus – insolvencyconsiderationsWhen is German insolvency lawrelevant?

German insolvency law applies when aborrower can file for insolvency inGermany, either through main orsecondary proceedings.

Main insolvency proceedings can beopened against a borrower where the“centre of main interest” of the borroweris based in Germany within the meaningof the European Council Regulation (EC)No. 1346/2000 (the “EU InsolvencyRegulation”). While there is a rebuttablepresumption that a company has its“centre of main interests” in thejurisdiction in which it has the place of itsregistered office, it is a question of factwhere the actual place of the “centre ofmain interest” is and this may alsochange with such facts.

After the opening of insolvencyproceedings in another member state ofthe EU, German courts will only have the

jurisdiction to open territorial secondaryinsolvency proceedings in Germany(liquidation proceedings restricted to theassets situated in Germany) if theborrower has an “establishment” inGermany. An “establishment” requiresthat the borrower carries out a non-transitory economic activity with humanmeans and goods. Further, a minimumlevel of organisation is required, so thatsimply the situation of assets of a personand the place where the obligors ofcontractual claims of a debtor aresituated should ordinarily not lead to“establishment” in that place. It istherefore unlikely that a foreign borrowerwho owns properties situated in Germanycould be subject to secondary insolvencyproceedings unless Germany is also aplace from which economic activities areexercised on the market and theseactivities are not purely occasional.

Where main insolvency proceedings areinitiated outside of a member state ofthe EU where the EU InsolvencyRegulation applies (this would berelevant where e.g. insolvencyproceedings are initiated in offshorecountries such as the Isle of Man or theChannel Islands), secondaryproceedings in Germany can be openedif the debtor has a branch in Germany orthe debtor has other assets located inGermany and the creditor filing anapplication has a particular interest inthe opening of such territorialproceedings. Such interest would needto be assessed on a case by case basis.The territorial proceedings would belimited to the assets located in Germany.

How can it become relevant?

If insolvency proceedings are opened inGermany, under certain circumstancesthe insolvency administrator maychallenge transactions which aredetrimental to other insolvency creditors,


89 New Horizons


subject to certain hardening periods.Where a challenge is successful, theassets that were the subject of therelevant challenged transaction have tobe returned to the estate and the originalconsideration for such assets (if any)becomes an unsecured claim against theinsolvency estate.

By way of example, any security given tothe lender whilst the borrower is unableto pay its debts when due may bechallenged and set aside if the lenderknew at the time of taking the securitythat the borrower was illiquid or if it hadknowledge of circumstances that couldlead to this conclusion. The hardeningperiod in this case is three months priorto the filing of a petition for the opening ofinsolvency proceedings.

Further, security granted which thesecurity provider was not contractuallyobliged to provide or not obliged toprovide at the time may be challenged. Inthis case, the hardening period is aminimum of one month, but an extendedhardening period of up to three monthsprior to the filing of a petition for thecommencement of insolvencyproceedings applies if the security isgiven either at a time when the personproviding the security is in a condition ofilliquidity or if the beneficiary knew thatthe granting of the security would bedetrimental to other creditors.

In other cases, hardening periods maybe longer (e.g. four years where a lenderhas been granted security and theborrower does not receive anyconsideration or benefit from thegranting of the security or ten yearswhere the security was granted by theborrower with the intention to harmcreditors and the beneficiary hasknowledge of such intention).

The question of whether an act of theborrower may be subject to challengemay also arise where the borrowerwaives a claim it may have against thesponsor as part of the overallrestructuring negotiations with the lender.

What can trigger a filing forinsolvency under German law?There are two reasons which compel thefiling for insolvency proceedings, over-indebtedness and illiquidity. Pendingilliquidity, i.e. a situation in whichmanagement of a company comes to theview that illiquidity, while not yetimminent, is pending, allowsmanagement to file voluntarily.

Over-indebtedness

Under German law, a situation where theassets are exceeded by liabilities is referredto as a status of over-indebtedness and, inthe case of a German borrower, unless(under an exemption which is in force until2014) a positive continuation prognosiscan be presented by management to suchGerman borrower, this triggers anobligation to file for insolvency withoutundue delay and no later than 21 calendardays following the assessment of suchover-indebtedness.

One question on which there is no clearanswer is whether a company theliabilities of which exceed the assets canhave can have a positive continuationprognosis in light of the arrival ofrepayment dates in CMBS loans whichcannot be moved without extension ofthe CMBS bonds. While a positivecontinuation prognosis requires a

predominant likelihood of the ability tomeet payment obligations as they fall dueduring the current and the next businessyear, there is still a certain discretion formanagement in assessing this.

Illiquidity

A borrower is considered to be illiquidwithin the meaning of German insolvencylaw where it is not able to pay its debtswhen due. Whether or not a creditoractually demands payment is not decisive– any payment obligations which are duehave to be considered. A temporaryliquidity gap (Liquiditätsengpass/Zahlungsstockung) of less than 2 weekswill not lead to illiquidity where such gapcan be closed by expected payments,new loans or the liquidation of assetswithin a short period of time. However,failure to provide for sufficient liquiditywithin such period will generally trigger anobligation to file for the opening ofinsolvency proceedings.

A borrower may also be considered illiquidif it is only unable to fulfil a small portion ofits payment obligations due, unless theamount is insignificant. In this context, theGerman Federal Court (Bundesgerichtshof)generally considers an amount of less than10% of the payment obligations due to beinsignificant.

Illiquidity may only be temporarily “cured”by a deferral of payments which preventsthe relevant payment obligations frombecoming due, however, a deferral coupledwith further restructuring measures asdescribed above may prove to be a usefultool for the reorganisation of a borrower.

ConclusionSome of the considerations above may be relevant to CMBS restructurings inGermany only. One aspect, however, that will be common to all jurisdictions is that thechoice of the appropriate restructuring measures will require a thorough commercialand legal analysis and depend on the willingness of all parties to cooperate.

New Horizons 90


16. Coeur Défense: French AppealCourt judgment reassures themarkets

The safeguard proceedings in relation tothese companies had previously cast asignificant chill on the French real estatefinance and CMBS markets.

Although the Coeur Défense decisionsare the subject of a challenge before theFrench Supreme Court, the two casesof 25 February 2010 have reassuredmarket participants and should deterfuture abuse of the safeguard procedurewhere the survival of the core activity ofa company is not threatened and theonly purpose of the proceeding is topreserve shareholders’ interests and tounilaterally impose on creditors a re-negotiation of their debts.

BackgroundThe judgments of 3 November 2008opening safeguard proceedings inrelation to Heart of La Défense SAS(“Heart SAS”) and its Luxembourgparent Sàrl Dame Luxembourg (“DameLux”), shocked the financial markets.Heart SAS was a special purposevehicle which was the borrower underthe EUR 1.64 billion property financingsecured on the Coeur Défense complexin La Défense. Dame Lux had provideda limited recourse share pledge(“cautionnement réel”) to secure thedebt of Heart SAS. The financing wasalso secured by other security interests,which included a French securityassignment of all claims under theleases of the Coeur Défense complexmade under the Loi Dailly regime.

The collapse of Lehman Brothersresulted in the downgrading of theLehman entity that provided an interest-rate hedge to Heart SAS, triggering anobligation upon Heart SAS to replacethis swap counterparty. Having failed tofind a substitute swap provider at an

equivalent cost, the President of HeartSAS filed for the opening of a safeguardproceeding and a similar filing wasmade for Dame Lux.

The markets had not anticipated thatsafeguard proceedings would beavailable in relation to a special purposecompany such as Heart SAS, and hadalso not anticipated that a Luxembourgholding company such as DameLuxembourg could be subject to Frenchsafeguard proceedings. Marketperception was exacerbated by the factthat the loan had been transferred tothe Fonds Commun de TitrisationWindermere XII under a securitisationtransaction.

Appeal court judgments of25 February 2010The judgments opening safeguardproceedings in respect of bothcompanies were annulled by the ParisCourt of Appeal:

Heart SASThe Paris Court of Appeal focused onthe core test for the opening ofsafeguard proceedings given by ArticleL. 620-1 of the French Code deCommerce, namely that the enterpriseis facing difficulties which it is not ableto overcome (at the time of thejudgment the test also included thatthese difficulties were of a natureleading to a cessation of payments).The purpose of the procedure is tofacilitate the re-organisation of anenterprise to permit it to pursue its

economic activity, maintain employmentand stabilise its liabilities.

In this context the Court focused on thefact that the core economic activity ofHeart SAS is the ownership of itsproperty at Coeur Défense and theactivity of exploiting this property byleasing it to its tenants. In a detailedfactual analysis the Court concludedthat at no point had Heart SAS proventhat it was in fact facing insurmountabledifficulties in pursuing its core activity ofleasing and profiting from its building.

The fact that Heart SAS was obliged toreplace a hedging swap with Lehmanby a swap with another counterparty atgreater cost and that, if it failed to doso, it could be in default under its loanagreement was not seen a sufficientreason to permit it to commencesafeguard proceedings. The higher costof this swap agreement did notdemonstrate an insurmountable difficultyin pursuing its core activity of leasing itsbuilding. Instead the Courtcharacterised the filing for subsequentproceedings by Heart SAS as anattempt by the company to mis-use thesafeguard proceedings to impose on itslenders a re-negotiation of the contractswhich it had entered into against civillaw principles. The fact that a defaultunder the loan could lead to a changeof shareholder by reason of theenforcement of the share pledgegranted by Dame Lux was not viewedas affecting the ability of Heart SAS topursue its activity.

In its judgment on 25 February 2010, the Paris Court of Appeal annulled the openingof safeguard proceedings in relation to Heart of La Défense SAS and Sàrl DameLuxembourg (FCT Windermere XII). A similar judgment was rendered on the sameday by the same court in the “Mansford” case, another real estate acquisitionstructured financing.

New Horizons 92

“The safeguard proceedings in relation to thesecompanies had previously cast a significant chill on theFrench real estate finance and CMBS markets”


Whilst the judgment does not excludethe use of safeguard proceedings forspecial purpose companies, it requiresa factual analysis of the real economicactivity of a company and clearlydivorces the survival of this activity fromthat of the ownership of theshareholding of a company.

Dame LuxThe Court took into account a numberof factors in reaching the conclusionthat the opening of safeguardproceedings in relation to Dame Luxwas not appropriate:

n its core economic activity is that ofacting as a holding company whichmanages a portfolio ofshareholdings;

n it had not demonstrated that it haditself suffered difficulties in pursuingits own activity;

n it had not demonstrated that theguarantee it had granted was otherthan of a limited recourse naturewhich would be discharged in fullupon the enforcement of the pledgeover the shares it holds in Heart SAS;

n after the enforcement of the pledgeover the shares in Heart SAS, DameLux would have sufficient financialmeans to pursue its core activity ofbeing a holding company.

Taking into account these factors thecourt concluded that it was notlegitimate for Dame Lux to initiatesafeguard proceedings solely for thepurpose of frustrating the enforcementof an out of court foreclosure provision

(pacte commissoire) over the shares itholds in Heart SAS - especially giventhat Heart SAS could pursue its coreactivity (of leasing and exploiting theCoeur Défense complex) regardless ofwho its shareholder was.

The Court did not explicitly address thequestion of whether Dame Lux had itscentre of main interests in France forthe purpose of the European InsolvencyRegulation.

Interest of creditors tooppose safeguardproceedingsThe Court considered that an individualcreditor had a personal and legitimateinterest different from the interest of itsdebtors the creditors collectively toappeal against the decision of thejudgments opening the safeguardproceedings (tierce opposition) whenthe debtor concerned has mis-used thesafeguard proceedings only to imposeon the creditor a re-negotiation of acontract or to frustrate the enforcementof a contractual right. The Courtconfirmed that such a creditor is entitledto appeal against the judgment openingthe safeguard proceedings, despite thefact that the interest of the creditors as

a whole is represented by a court-appointed officer.

Dailly security assignmentUnder Loi Dailly, the transfer of thereceivables is enforceable as against theassignor and its third party creditorsupon the dating of the form ofassignment. The Paris Court of Appealconfirmed that the validity andenforceability of a Loi Dailly securityassignment are not affected by theopening of insolvency proceedings inrespect of the assignor of thereceivables. The beneficiary of a LoiDailly assignment can notify theassigned debtors notwithstanding theopening of insolvency proceedings inrespect of the assignor. The CoeurDefense case confirmed that thenotification is only a means of disclosingthe transfer of the receivables to theassigned debtors and should not becharacterised as an enforcement of asecurity interest even when thereceivables are transferred by way ofsecurity. As from the date on which thedebtors of the assigned receivables areproperly notified in accordance with theLoi Dailly assignment, they can onlyvalidly discharge the correspondingdebt by paying the assignee.


93 New Horizons

“The Court characterised the filing for subsequentproceedings by Heart SAS as an attempt to abuse thesafeguard proceedings to impose on its lenders are-negotiation of the contracts which it had entered intoagainst civil law principles”

New Horizons 94


17. Japanese CMBS market – thestory so far...

The dearth of funding put an end to newtransactions and the subsequentdeterioration of the state of the Japaneseeconomy put existing transactions undersignificant stress. Sponsors are now facedwith falling property values on one handand limited refinancing opportunities onthe other due to persistently difficultfunding conditions.

This article looks at how parties to existingJapanese CMBS transactions have beendealing with the impact of falling propertyvaluations. Although the observations aremade from the perspective of Japaneselaw and market practice, they shouldprovide useful guidance to parties insimilar situations in other jurisdictions.

With valuations continuing to fall aroundthe world, restructuring solutions remainlimited including in Japan. A developingtheme in the Japanese CMBS market is astructure which enables the parties toavoid a fire sale of the assets, henceallowing for maximum recovery throughan orderly sale of assets. One suchstructure is to amend the loan documentsin order to introduce an asset disposaland amortisation schedule together withan extension of the maturity date in acommercially acceptable timetable for anorderly disposal of assets. The lenderusually has control over the sale price andidentity of any buyer, although it is notuncommon to see an asset manager witha strong bargaining position retain somecontrol over that process. Proper financialincentives for the asset manager areimportant if the lender intends to rely onthe asset manager to carry out the assetdisposal plan. Therefore, LTV breachesare usually waived in these circumstancesto allow for funds to flow through to paythe disposal and incentive fees to theasset manager. This proposed structurecould also work for securitised deals,however any actions of the lender or

asset manager may be restricted bybondholder instructions. Any waivers orproposed amendments to the loandocuments, for example, will also typicallyrequire bondholder consent.

A lender with sufficient resources and therelevant licence to perform assetmanagement may choose to terminatethe asset management agreement andtake over the functions of the assetmanager or appoint a new asset managerto carry out the asset disposal plan(although it is unlikely that a CMBS issuerwould have these resources or a licence).The advantage in doing this is to removea potentially uncooperative party from thetransaction so as to facilitate enforcementand to avoid paying unnecessary assetmanagement fees. A lender should bewary as to whether there are sufficientlegal grounds to terminate the assetmanagement agreement. For instance, anLTV breach may not constitute an event ofdefault which is often the event giving riseto the lenders’ right to terminate the assetmanagement agreement. A lender is likelyto be exercising its rights to terminate theasset management agreement under theterms of the security that has beengranted over the asset managementagreement and these terms may containgrace and cure periods in respect ofany termination.

Where a lender needs to enforce itssecurity, the most common solution is torequire the borrower to sell the propertyvoluntarily to a third party buyer identifiedby and on terms approved by the lender.Other alternatives include foreclosure orrequiring the borrower to sell the propertyto the lender and setting off theoutstanding loan amount. These requirethe lender to take the asset on to itsbalance sheet which is often an unpopularoption or indeed a legal or regulatoryimpossibility for that particular lender.

These are also unpopular options forsecuritisation issuers.

In Japan, as in other CMBS markets,CMBS loan assets often have amezzanine piece which is held by anotherlender. The rights of the mezzanine lenderas against the senior lender have to beexamined carefully as these may rangefrom (i) a relatively weak mezzanineposition where the mezzanine lender haslittle more than a six to nine monthmezzanine administration period and aright to cure through to (ii) a significantlystronger position where it has veto rightsto a wide range of amendments,consents and waivers, including theintroduction of an amortisation schedulefor the senior loan or the replacement ofthe asset manager. In suchcircumstances, the risk of deadlock innegotiations can be significant if themezzanine position has already sufferedtotal or close to total loss.

An interesting development since thesummer of 2009 is the appetite ofinvestors to refinance the mezzaninepiece, thereby removing any risk ofdeadlock. Such investors would structuresomething with limited downside, such asa loan instrument at the mezzanine levelwith high yielding and possibly payment-in-kind (PIK) coupon, and an equity kickerto allow them to reap the upside if there isa recovery in the property market duringthe term of the restructured financing.

As the maturities of Japanese CMBSloom and existing transactions comeunder increasing stress, we expect thatmore restructurings and enforcements willbe carried out by the lenders themselves.The appearance of new investors is anencouraging sign for the market as thedistressed situation and falling valuationsare interpreted by some as an opportunityto enter (or to re-enter) the market.

In the run up to the credit crisis in 2008, the Japanese CMBS market experienced aperiod of record activity that reached its peak in 2007. As was the case for CMBSmarkets around the world, the Japanese CMBS market was not spared by the creditcrisis of 2008.

New Horizons 96


18. Assessing the impact of Rome Idevelopments in the context oftrade receivables financings

The Rome ConventionThe Rome Convention has generallybeen a success because of itsemphasis on freedom of choice. Itprotected weaker parties, such asemployees and consumers, but mostcommercial parties were given thefreedom to choose the law they wantedto govern their contracts. Where theparties have not chosen the applicablelaw, the Convention provides that acontract is governed by the law of thecountry with which it is most closelyconnected, which it presumes to be thelaw of the habitual residence of theparty which is to effect the performancecharacteristic of the contract.. Thispresumption as to the governing law isrebuttable – meaning a party couldseeking to argue that another governinglaw should apply.

Changes under Rome IThe Commission’s proposal for theRome I Regulation (the “Regulation”)included significant changes to the textof the Rome Convention. TheCommission had not consulted on thechanges, and, further, refused toconduct an impact assessment on theireffect because, it asserted, they wereonly minor and would have little impact.This led to two years of wrangling overthe Regulation. However, the final form ofRome I broadly has the same effect asthe Rome Convention. Crucially, partiesare still largely free to adopt a governinglaw of their choice and rules apply todetermine the implied governing law if nogoverning law is selected in the contract.

Impact on tradereceivables financingIn most trade receivables financingswhere receivables are assigned by theoriginating entity to the financier or aspecial purpose company, the governinglaw of the assignment will be the lawexpressly chosen in the assignmentcontract, unless the contract impacts ona limited range of legal issues, such ascertain mandatory law provisions or thecontract involves consumers, which isunlikely. However, the law governing thecontract creating the receivables (the“debt contract”) between the obligor andthe assignor may not have beenexpressly chosen. In the event that noexpress choice of governing law ismade, Rome I has made the process ofdetermining which law is most closelyconnected to a contract morestraightforward as eight rules have beenincluded to indicate which will be therelevant law for specified types ofcontracts.. These changes increase theclarity of the provisions and thereforeincrease the predictability of theregulation's application.

If no express chose of law is made,unless another governing law is provedto be more closely connected to thecontract, then the governing law of thedebt contract will be that of thejurisdiction in which the seller of goodsor supplier of services has theirhabitual residence. For companies thiswill be the location of the principalplace of business.

To illustrate the application of theserules, if a seller of goods is based in

Germany this will create a presumptionthat German law is the governing law ofthe agreement under which the goodsare sold, and only if another governinglaw is obviously more appropriate wouldGerman law not apply.

The law governing the debt contract willalso be relevant as lenders will wish toperform due diligence on thesecontracts to ensure that the receivablehas been validly created and that thereceivable will be validly assigned. Thegoverning law of the debt contract willdetermine whether the relevant claimhas been validly assigned, as well asestablish the relationship between theassignee and debtor (including theconditions under which suchassignment can be invoked against thedebtor or whether the debtor'sobligations have been validlydischarged). This applies to transfers ofclaims by way of security and pledgesas well as outright transfers. It ispossible that the governing law of thedebt contract and the governing law ofthe assignment will be different,although in securitisation-type tradereceivables financing they tend to bethe same.

Confusingly, a third law may be relevantas the law governing priority as betweensuccessive assignees and the lawgoverning the effectiveness of anassignment against third parties has notbeen provided for in Rome I, althoughRome I does provide for a review ofthese provisions to be completed by 17June 2010. In advance of this deadline,Member States have been consulting

From 17 December 2009, Rome I1 has replaced the Rome Convention2 in determiningthe governing law of contracts.

This article examines the changes that Rome I has brought about from the perspectiveof secured lenders involved in trade receivables financing, before examining theconcerns of the markets and considering what the changes mean for commercialentities on a practical level.

New Horizons 98

1 Regulation (EC) No. 593/2008 of 17 June 20082 Convention on the Law Applicable to Contractual Obligations of 1980


with industry and, in the UnitedKingdom, the Ministry of Justice hasbeen consulting on two proposalsnamely, using the law of the habitualresidence of the assignor or using thelaw of the debt contract. CliffordChance’s Structured Debt Groupresponded to these proposals andsupported the law of the debt contractbeing the law governing priorities andeffectiveness of an assignment againstthird parties. Our consultation responsehas been made public, however, insummary, the priority of competingassignees is not relevant to tradereceivables financing structures or othersecuritisation structures because therating agencies permit certainassumptions to be made in the legalopinion analysing the legal risks in aparticular securitisation transaction.Typical permitted assumptions are thatthe parties will comply with theirobligations under the transactiondocuments and that there will be nofraud. These assumptions, readtogether with a typical covenant by the

originator not to assign the receivablesto any person other than as set out inthe transaction documents, removes thedetermination of the priority ofassignments from the analysis of thelegal risks of a particular securitisationtransaction.

The law governing the effectiveness ofthe assignment against third parties willbe relevant to trade receivablesfinancing and securitisation structuresand, as the law of the debt contract isalready subject to due diligence for thepurposes of the “true sale” opinion, wesupport the proposition that the law ofthe debt contract should also governthe effectiveness of the assignmentagainst third parties. We have concernsthat the law of the habitual residence ofthe assignor may change and/or maybe difficult to determine. Furthermore, itmay result in an additional 'third' lawbeing relevant to the effectiveness ofthe receivables assignment potentiallycreating conflicts of law issues anddecreasing legal certainty.


99 New Horizons

ConclusionTrade receivables financiers willwelcome the freedom to choose thegoverning law of the assignmentcontract being preserved in Rome I.However, the industry will be watchingthe outcome of the negotiationsbetween Member States with respectto the law governing the effectivenessof assignments against third parties.

New Horizons 100



101 New Horizons

Esther CavettPartner, London

T: +44 20 7006 2847M: +44 77 7591 1251E: [email protected]

Susan RosePartner, London


Corporate Trusts

Clifford Chance contacts (London)To discuss any of the issues in this publication, please contact one of our market experts below:

Claude Brown Partner, London


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Jessica LittlewoodPartner, London


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Structured Debt

Clifford Chance contacts (Global)

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Structured Debt

New Horizons 102

Tanja SvetinaPartner, Milan


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103 New Horizons


Gareth OldPartner, New York

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Richard Blewett

Timothy Cleary

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Marie-Isabelle Palacios-Hardy

James Pedley

Michelle Savage

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We would like to thank the following people for their contributions to this publication:

Acknowledgements

© Clifford Chance LLP, June 2010.

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This publication does not necessarily deal with every important topic nor coverevery aspect of the topics with which it deals. It is not designed to provide legalor other advice.

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